Business New Europe February 2013 edition

Inside this issue: Investigating Ukraine's Highway to Latvia The prince and the boozer Reality bites in Serbia Sokh'd in southern Kyrgyzstan February 2013 www.businessneweurope.eu

Special Report: CEE-net

RETURN OF THE SNOLLYGOSTER CEE is plagued by shrewd politicians not guided by principles

How to invest in Eastern Europe and China

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Contents

Editor-in-chief: Ben Aris (Moscow)

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Managing editor: Nicholas Watson (Prague)

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News editor: Tim Gosling (Prague)

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Eastern Europe: Graham Stack (Kyiv)

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Central Europe: Robert Smyth (Budapest) Jan Cienski (Warsaw) Mike Collier (Riga) Matthew Day (Warsaw) Tom Nicholson (Bratislava) Kester Eddy (Budapest) Steven Roman (Tallinn)

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Southeast Europe: Justin Vela (Istanbul) David O'Byrne (Istanbul) Bernard Kennedy (Ankara) Ian Bancroft (Belgrade) Bogdan Preda (Bucharest) Branimir Kondov (Sofia) Guy Norton (Zagreb)

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Alec Egan Business Development Director (International)

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COVER STORY 6 The Insiders

35

CENTRAL EUROPE 26 Another banner year for CEE bonds?

8 Return of the snollygoster 12 Perspective

28 Baltic banks at the "Hearts" of Ukraine graft

13 Chart of the month

31 The prince and the boozer 33 Problem lands in Karel's lap

EASTERN EUROPE 14 Investigating Ukraine's Highway to Latvia

35 Terminal illnesses in the Baltics

18 Suffer the little children

37 Juggling sewers and motorways in the EU

20 Orient Express Bank builds from bottom up

39 Poland mulls new scheme to give LOT its wings

Cover image: Illarion Gordon

21 End of an era in Russian banking

40 Fired over Hollywood dreams

Please direct comments, letters, press releases and other editorial enquires to editor@bne.eu

22 Russian automaker learns to run like a GAZelle

Design: Olga Gusarova-Tchalenko

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24 Russia's Etalon builds for the middle

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Contents

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We do them.

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EURASIA

SPECIAL REPORT

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Reality bites in Serbia

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Least free

62

Online and on fire in Russia

43

Slovenes fail to come clean

54

Sargsyan's second term

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Russians go online to hit the world's January sales

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Bulgaria's "meaningless" referendum

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Sokh'd in southern Kyrgyzstan

65

Russian reading habits change

Build it and they will come to Turkey

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Drug companies target Kazakh market

65

Tinkoff brings online advertising to Russia

48

Pegasus flies

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66 49

Albania pulls the plug on CEZ

Russians like their data on the move

OPINION

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50

Croatia's clothing industry looks to smarten up its act

New kids on the Czech tech block

New Ukraine govt a compromise between Donetsk groups

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AVG breaks out of security net

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The Arta doing business in Kazakhstan

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UPCOMING EVENTS

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Best Regional Bank in Central and Eastern Europe

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59

Turkmen trade

6

I The Insiders

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Difficult choices for Ukraine lie ahead

domestic demand, while drawing down scarce forex reserves, which have fallen by around one-quarter over the past year.

Risks are now of a large and disruptive currency correction, which could have a deeper and more systemic impact on the economy, particularly the banking sector.

Tim Ash of Standard Bank

While the regime's strategy in the run-up to parliamentary elections had perhaps been to buy time and hold the line, time is now running out and Ukraine is urgently in need of external assistance. Given geopolitical realities, the Yanukovych administration faces the choice of either turning to the International Monetary Fund (IMF) and the West for support, or eastwards to Russia. And yet neither option appears particularly palatable for a regime that seems intent on maintaining power and control this side of presidential elections.

P

arliamentary elections in Ukraine in October have failed to produce much clarity in terms of the economic and political outlook for the country. The elections brought "victory" for the incumbent Regions of Ukraine party, yet despite changes to electoral rules which favoured the ruling party Regions saw both its share of the popular vote and its seat allocation in parliament fall. Regions has since been able to forge a ruling coalition with the support of the Communists, but with the strong showing of the opposition and the focus now on presidential elections due in 2015, support for the ruling coalition appears less than whole-hearted.

Regions is not expected to enjoy a consistent majority but will likely rely on situational alliances, which suggests a somewhat fraught parliamentary term and an uneasy course on the economic policy reform front.

Even within the ruling party tensions appear to run deep between the various factions, driven by different and competing oligarchic groups and an increasingly powerful centre ranged around President Viktor Yanukovych and his so-called "family". Similar in many respects to the family circle that increasingly dominated the latter years of the Yeltsin era in Russia, the Yanukovych "family" is concentrating political and economic power and influence, and increasingly also control over the police and security services, plus the National Bank of Ukraine (NBU). This concentration of power around the "family" is itself creating fissures at the heart of Regions, which recently saw the departure of previously loyal and reformist ministers from the cabinet, including Serhiy Tyhipko and Valery Khoroshkovsky.

Political tensions have hardly been helped by the imprisonment of a number of leading opposition politicians, including the former prime minister, Yulia Tymoshenko, but also her former minister of interior, Yuri Lutsenko. The opposition and western governments have argued that the charges have been trumped up, and that the prosecutions represent the selective application of justice for political gain. They argue that the imprisonment of Tymoshenko et al, combined with changes in the electoral law, which ensured Regions took a majority

in parliament with just 30% of the popular vote, suggest a significant step back in terms of basic democratic standards, and the hard fought gains from the Orange Revolution.

Economic fallout The somewhat uncertain outlook for parliamentary politics, democracy and stability – parliament's work is frequently now marred by sit-ins and fisticuffs – plus coalition tensions and rivalries comes at an inopportune time, as Ukraine faces numerous challenges on the economic policy front.

The economy is stalling as global factors – weak demand for metals, which comprise 40% of exports – combine with specific domestic factors, including heightened risk perceptions around the elections, the concentration of power around the Yanukovych family, weak banks, an uncertain and often market unfriendly policy environment, to put the economy to the brink of recession. Full-year real GDP growth thus slowed

"Both Russia and the West are beginning to understand how to read the regime in Kyiv"

to just above zero in 2012, and the economy is expected to contract in 2013. Weak growth, structural weaknesses, and pre-election pork barrelling boosted the budget deficit to around 5% of GDP in 2012, and fiscal revenues look set to take a further hit in 2013. Despite the weak growth backdrop, the current account deficit rose to reach the equivalent of 6.5-7.0% of GDP in 2012, and with a weight of external liabilities falling due, concern has mounted over the ability of the country to finance itself and also for the Ukrainian hryvnia to remain stable. The NBU has defended the hryvnia resolutely, keeping monetary policy tight, thereby squeezing

In theory, Moscow could provide cheap energy and financing in abundance – but such support comes with strings attached.

In the short term, Russia wants control of strategic assets in Ukraine, particularly pipelines and energy sector assets.

Over the longer term, Moscow likely wants broader economic and political control over Ukraine, and one lever for this is perhaps its drive for Kyiv to join the Customs Union as a precursor to membership of the Eurasian Economic Union, which is developing between Russia, Belarus and Kazakhstan but is set to take in more members of the old Soviet Union.

Years of broken promises and agreements, have, however, left little trust between the two states. Perhaps mindful of the dire economic situation that Ukraine currently finds itself in, Moscow appears in no mood to compromise on its wish list. In parallel, and perhaps at risk of overplaying its own hand, the Yanukovych administration seems in no particular rush to cut a deal with Moscow.

In part, the government's willingness to call Moscow's bluff may reflect its assumption that it can fall back on IMF financing. A track record of relatively soft IMF programmes, often with front-loaded disbursements and all too often weak conditionality, perhaps underpins this optimism. However, there is much to suggest that cutting a deal with the IMF will be much more difficult than in the past. First, across the region, and reflective of flush global market conditions, the IMF appears to be becoming much tougher with potential borrowers, exemplified by its recent tough stance towards agreeing new programmes with Hungary and Serbia. Second, the IMF is perhaps finally in recognition that this Ukrainian administration has delivered very little on the conditionality attached to the existing, off-track, programme. Third, key IMF demands for gas price hikes, greater exchange rate flexibility and fiscal consolidation will be difficult for an unpopular administration to deliver on given a fractious parliament and the presidential elections due in 2015. Fourth, key western IMF shareholders appear in no mood to plead on behalf of the Yanukovych administration while key opposition leaders remain in jail and when there is real concern over the deterioration in basic political standards in Ukraine.

In conclusion, the above suggests considerable challenges lie ahead for Ukraine, ranging for heightened domestic political risks, potential for strained foreign relations with Russia and the West, set again a backdrop of a significant deterioration in the economy. The Yanukovych administration will soon have to make difficult choices – either it agrees deeper integration with Russia, or greater economic reform and liberalisation, which would likely be part and parcel of an IMF deal. However, the price of the latter could yet be a

"The Yanukovych family is concentrating political and economic power and influence, and increasingly also control over the police and security services" firmer commitment to maintain and defend the democratic standards that were so craved by the population in the Orange Revolution. And yet the regime's declining popularity, and perhaps its Soviet-era instincts, makes it incline towards more rather than less control, and less political liberalisation.

The regime's instinct is to play tactically for time, rather than to think long term and more strategically.

The problem is that both Russia and the West are beginning to understand how to read the regime in Kyiv, and its bluff may well be called by both sides.

Tim Ash is head of emerging market research at Standard Bank

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I Cover story

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T

here is a brilliant word that has oddly fallen out of use, especially given the way that leaders in bne's region have been running their countries in recent years. "Snollygoster" was coined in the 19th century and means: "A shrewd person not guided by principles, especially a politician."

The last time this word was used by anyone prominent was in 1952 by then US president Harry Truman (who got it wrong and thought it meant "bastard").

The word was born in the freewheeling days of America's youth when the country was a lot less democratic than it is today. In those days it was common to find politicians under the sway of men like rail tycoon EH Harriman or financier JP Morgan. The Oxford English Dictionary defined it simply as "shyster" in 1845.

Over the last 200 years the word has fallen out of use after checks and balances were introduced and transparency increased to the point where snollygosters in government found it difficult to get away with solely serving themselves anymore – at least in theory: the power of big corporations and the revolving door that connects Wall Street and the Mall in Washington DC these days would suggest the opposite. But the word is a lot more pertinent to the transition states of Central and Eastern Europe and the Commonwealth of Independent States (CEE/CIS), which are suffering from the same snollygoster problem as the US did shortly after its independence.

Return of the snollygoster Ben Aris in Moscow

Etymologists believe that one possible root of the word is "snallygoster" – a mythical beast, half-reptile and half-bird, invented by slave owners in Maryland to scare their slaves out of voting. Most governments in CEE/CIS are not above using similar blunt tactics to ensure their own grip on power. Put the other way round: the genuinely honest politician in the region operates at a significant disadvantage.

Where there's smoke there must be fire No place better illustrates this problem than Ukraine – once hailed as the "only

Cover Story I 9

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true democracy in Eastern Europe" following the triumph of the Orange Revolution in 2004.

Legal cigarette sales in the Ukraine tumbled again in 2012 and are expected to fall further this year from 80bn cigarettes to 75bn, Yuriy Kyshko, director for corporate issues at Imperial Tobacco Ukraine, told Interfax-Ukraine in January. Kyshko says the problem is not just the increase in smuggling of cigarettes, but the rise in the production of counterfeits, which now account for 4.4% of total sales, according to Imperial Tobacco's analysis. "There has never been such a high level of counterfeit products on the cigarette market," Kyshko said.

Cigarettes are at the very bottom of the consumer goods food chain, but worth a lot of money. Cheap and always in demand, they were the very first product to arrive in the newly liberated markets of the east back in 1991. For Ukraine's government to have lost control of this business (and its associated tax revenue) to criminal gangs testifies to the speed at which the country is falling apart. Ukraine is rapidly going to the dogs.

The country's industrial production slumped 7.6% on year in 2012, its hard currency reserves are dwindling at an alarming rate and, in a sign of things to come, its largest airline AeroSvit went bust in December. In January, Prime Minister Mykola Azarov predicted the economy would grow by 3-4% this year, but the European Bank for Reconstruction and Development (EBRD) countered a few days later by cutting its growth forecast to only 1%. The International Monetary Fund (IMF) was due in Kyiv in the last days of January to restart negotiations on the stalled $15.4bn loan programme without which the country is facing the prospects of a debilitating devaluation and financial crisis.

How did Ukraine get into such a mess?

In the second half of the 1990s the economy was growing by over 10%, the equity market was the world's best performing in the years after the Orange

Revolution, and the rise of the middle class fed a bank-acquisition bonanza in 2006-2007. But the combination of a weak president and entrenched snollygosters prevented the Orange team from making much progress. The nail in the coffin was the 2010 presidential election, ironically the freest and fairest ever seen in the former Soviet Union, in which Viktor Yanukovych beat out Yulia Tymoshenko for the country's top job by only a few percent.

By taking control of both the Rada and the president's office, Yanukovych and his Party of Regions were in a position to actually move ahead on the reform agenda and capitalise on Ukraine's

the country, most presidents stack the cabinet with their friends and leave the economic reforms for later.

Without any functioning institutions or system of accountability, in the early stages the course the country follows is also heavily dependent on the moral character of its leader. Islam Karimov has been a disaster for Uzbekistan, but Estonia's first president, Lennart Meri, was a gift that the tiny Baltic country is still enjoying.

The performance of most leaders in the former Soviet Union lies somewhere between these two poles, with the majority tending toward Karimov's end.

"The transition to an effective government is as much an HR problem as it is a question of holding fair elections" obvious potential. What he did instead was to simply capitalise on his position.

In the midst of a global economic crisis, Yanukovych decided it was a good time to build himself a new presidential palace, the Mezhyhirya residence, at a reported cost of over $9m, to mention only one example. Yanukovych is a snollygoster of the first order.

The Family Man takes charge Ukraine has become a textbook illustration of the snollygoster problem. The transition to an effective government is as much an HR problem as it is a question of holding fair elections. The incoming president of a transition state faces a parliament that is typically stacked with snollygosters, as the first generation of politicians are usually the most ruthless ones who use their own money, then state funds, to buy and keep power.

Once in the job, the president's first task is to stay there. If he is a true reformer, the first job of the snollygosters is to get rid of him. Faced with a choice between consolidating raw power and reforming

However, a few like Russia's Vladimir Putin and Kazakhstan's Nursultan Nazarbayev are probably closer to the middle of the spectrum. Both men have enriched themselves – if press reports are to be believed Putin is one of the five richest men in the world and all the significant assets in Kazakhstan belong to the Nazarbayev family – but both men have overseen significant liberalisations that have also enriched many of their citizens.

Geography plays a role too: little countries are a lot easier to reform than big ones. Georgia's Mikheil Saakashvili is generally seen as one of the most progressive leaders in the CIS and famously ended corruption amongst the traffic police by sacking the entire force overnight. But Saakashvili only needed two deputies to oversee the job of hiring replacements. Russia's police force runs into the millions and the president can only be superficially involved in the hiring process. As Deputy Prime Minister Arkady Dvorkovich told bne in an interview last year: "We can't force reforms on the regions from a federal

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level. We have to get the regional governors on board first."

Ukraine today looks very much like Russia in the 1990s under Boris Yeltsin.

Both have clans close to the president dubbed "the Family" and in both the oligarchs (by definition snollygosters) are very close to the government. In Yeltsin's day, the Family clan was run by his daughter and her husband, the Kremlin chief-of-staff Valentine Yumashev. Billionaires Roman Abram-

"Ukraine has become a textbook illustration of the snollygoster problem" ovich and Oleg Deripaska (who married Yumashev's daughter) were also key members. In Ukraine it is Yanukovych's two sons who are in charge, while oligarch and owner of System Capital Management, Rinat Akhmetov (the richest man in the whole CIS), is also a Rada deputy and clan leader. "In the medium term it seems unlikely that Ukraine's oligarchic system could cease to exist as it would demand a deep and far-reaching transformation of Ukrainian politics and economy," Wojciech Kononczuk, an analyst for Warsawbased Centre for Eastern Studies (OSW), wrote in the Kyiv Post. "At the moment it is hard to identify any strong political force which is interested in a 'de-oligarchisation' of Ukraine and – what is crucial – has the instruments to perform such a change."

Breaking the mould Ukraine's venal politico-oligarchic system highlights the dangers of rapid change. Revolutions or even elections are not enough to put a country on the right path. The bureaucratic-client system needs to be smashed and replaced with something more accountable.

On taking office in 2000 this is exactly what Russia's Putin did. Within months, he had smashed the politico-oligarchic system by driving two oligarchs into exile – media mogul Vladimir Gusinsky

and Boris Berezovsky – and dissolving the Federal Council, Russia's upper house of parliament, as most of the deputies were in the pocket of the business groups. As a result, the economy quickly started to boom (helped by rising oil prices). The western perspective is that Yeltsin was good (democratic) and Putin bad (authoritarian). However, the Russians have a different view: Yeltsin (chaos and poverty), Putin (stability and prosperity). "Since [the 1990s], the relations between the Kremlin and big businessmen has changed completely," says Kononczuk. "However, at present, big business does not have such a strong and decisive influence on politics in any other Eastern European country as it does in Ukraine."

Putin's mistake was to, naturally enough, appoint his friends from the security services to his own administration, who went on to become the so-called Siloviki faction. Chosen on the basis of their loyalty to the president, unsurprisingly plenty of snollygosters were awarded high office.

Is Putin a snollygoster? This is a difficult question to answer. Certainly he is no Nelson Mandela or Aung San Suu Kyi. The best way to sort the snollygosters from the merely egotistical and fairly corrupt president is to see how much public debate they allow. Debate is the hallmark of democracy and the core of representative government where everyone can have their say before a compromise is thrashed out.

In countries like Ukraine, Belarus and Uzbekistan there is little to no debate, but in countries like Russia and those in Central Europe there is a lively and continuous debate over policy. Russia is currently facing some very big choices about where its future lies, and what is remarkable is not that there is no consensus on how to deal with these issues, but that the debate is so public.

The really interesting question is to what extent the snollygoster problem is inevitable? Estonia's Meri managed to avoid it almost completely, but then he had only 1.5m people to supervise – the size of one regional Russian city.

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Snollygosters will inevitably creep into positions of power in a system as large as Russia's. Putin should have done more to rein in his snollygosters, but by smashing the Yeltsin system he has definitely taken Russia further forward. "The problem the Siloviki face is that they may control the state's cash, but they don't have title to it," says Sergei Guriev, rector of Moscow's New Economic School. "The oligarchs have been smart, as they own all their companies outright. That will make it hard to take these assets away.

But the Siloviki don't own anything and will have a problem legitimising their wealth should they ever leave government."

Things to do The snollygoster problem is not limited to Russia and Ukraine – or even to the CEE/CIS region; there are snollygosters galore in the West too. Ex-Italian prime minister Silvio Berlusconi's name springs immediately to mind; a succession of Greek premiers would also feature high on the list. Closer to home, Hungary and Romania are probably the biggest victims of snollygosters in power of all the countries in Emerging Europe.

Over the past decade, the Hungarian economy has repeatedly disappointed and it seems as if investors have simply written off the country in terms of its economy and markets being able to perform like those of a normal western state. "At the core of Hungary's problems is a dysfunctional political system and currently a government that is extremely hostile to foreign investors," Lars Christensen, head of emerging market research at Danske Bank, said in a recent note. "The result has been that the economy has basically seen no growth for more than six years."

The whole issue of how to deal with the ubiquitous snollygosters that make these countries "dysfunctional" hasn't really entered into the debate of how to transform these countries – and this is equally true of the nascent opposition parties.

The default solution is simply to sweep bad governments away and hold fresh

Cover story

elections. Russia's famous opposition journalist Masha Gessen offered an unusually explicit comment on this topic when asked what was her "best case" scenario for Russia's opposition during an interview with Bloomberg's Charlie Rose last year. She said she hoped there would be a mass protest that led Putin to order his troops to fire on the crowds, an order they refused to follow, which resulted in his government being swept from power to be replaced by an interim government followed by open general elections.

But this is exactly what happened in Russia in 1991, in Ukraine in 2004, in the subsequent "coloured revolutions" in the former Soviet Union, and most recently in North Africa last year. With the possible exception of Georgia, none of these changes has resulted in much improvement in either standards of living or the quality of government. In almost all cases, the citizens are worse off than they were before.

This reality is not lost on Russians, who have seen their lives transformed over the last decade. Unlike the 20-something, unemployed Arabs that fuelled the Arab Spring demonstrations, it's the middle-aged middle classes who have the most to lose from a chaotic change of power that populate the ranks of Russia's protest movement.

More emphasis needs to be placed on improving transparency as a first step in dealing with the snollygoster problem.

Ironically, the Russian government has already started taking baby steps in this direction. In December, several laws were passed that will force not only Duma deputies (and their families)

I 11

to declare their personal wealth, but extended this rule to civil servants too.

From this year, any asset worth more than three-times a bureaucrat's annual income must be declared and accounted for on pain of confiscation and/or dismissal.

Ideally, boosting the rule of law and accountability before the law is the ultimate protection against snollygosters taking over, but as the US found out this is the work of years, if not decades. In the meantime, the press is in a position to play a unique and important role in the fight against the snollygosters of the east. It is one of the few democratic institutions – in its role of the fourth estate – that can be rapidly deployed against the worst abuses. But the press remains muzzled in the east. It is not for nothing that Putin targeted Gusinsky when breaking up Yeltsin's system, as the oligarch owned news channel NTV, then Russia's most powerful independent broadcaster.

The western press doesn't offer much more succour, as there are plenty of snollygosters among the international press corps too, although their position is complicated by the slow-burning crisis that the news business is facing since the advent of the internet. There is considerable pressure from editors in London and New York to "sex up" the story, and demonizing an obviously imperfect president is a lot easier to sell in the newsroom than going into the subtleties of the challenges that transition countries are grappling with.

The upshot has been a race to the bottom among most famous titles.

"Yanukovych is a snollygoster of the first order"

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I Perspective

Is the worst over for Emerging Europe?

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The EBRD says the effects of the Eurozone slowdown are belatedly catching up with Poland, causing growth to decline markedly from the second quarter of 2012, to likely average 2% for last year. "Weaker exports, coupled with reduced private investment and the fiscal consolidation evident reduced public capital spending will persist in the first half of this year, and the EBRD's reduced 2013 forecast is 1.5%."

the continued weak business environment, addressing skills gaps at the regional level, and leveraging Russia’s enormous regional diversity," it says.

Slovenia and Hungary, it says, remain mired in recession, with banking sectors in both countries contracting sharply.

By contrast, the growth put in by the Baltic countries in the second half of last year appears to have exceeded expectations.

Turkey's relatively loose links with the troubled Eurozone – aside from its reliance on bank finance form there – helped the country ward off the worst of the effects of the crisis last year, and the EBRD forecasts for 2013 growth at 3.7%.

Hungary in particular will suffer this year due to erratic policymaking and a concurrent slowdown in bank lending.

The EBRD says Hungary is due to finish 2013 still locked in recession, albeit only just, with a full-year contraction put at 0.1%. "Hungary entered a renewed recession in early 2012 as weaknesses in export markets added to the ongoing stagnation in domestic demand, resulting in an overall contraction of about 1.5% in 2012," the report states. "The investment rate is now among the lowest in the EU. This slowdown accelerated due to further retrenchment in credit to the private sector (which contracted by over 6% of GDP in 2012), as the country shows the most rapid pace of bank deleveraging of any transition country."

After a strong growth performance fuelled by a credit boom in 2011 that saw GDP boom by 8.5%, the Turkish economy

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A

fter a difficult 2012, Emerging Europe will be hoping the European Bank for Reconstruction and Development (EBRD) is right in its latest economic outlook that falling risks in the Eurozone mean the economic slowdown in the region likely bottomed out in the fourth quarter of last year.

"Signs of stabilisation in the Eurozone are reducing the risks facing Emerging Europe, leading to cautious optimism that the worst of the transition region's problems may slowly be drawing to a close," the development bank writes in the report published on January 21. "After a sharp slowdown in economic activity in 2012, the EBRD's economists are expecting a moderate acceleration of growth this year. Across the whole transition region, the EBRD expects growth of 3.1% in 2013, after a sharp slowdown to 2.6% in 2012 from 4.6% in 2011.

While the 2013 forecast for Emerging Europe overall is marginally lower than the 3.2% the EBRD suggested in its last economic outlook in October, the analysts are clearly more optimistic than for some months. Chief Economist Erik Berglof said, "For the first time in a long while we are now seeing the possibility of a reduction in the risks facing emerging Europe, especially the risks from the eurozone. It is too early to sound the all-clear but there are signs of stabilisation."

That said, Poland and Slovakia, the two economies deemed to have outperformed throughout the crisis, are set for a much tougher time in 2013, the report warns. "Recent developments suggest that stagnation in the core Eurozone has finally caught up with the two erstwhile strongest performers, Poland and the Slovak Republic."

The Baltic countries see estimates for their economic growth raised in both 2012 and 2013 compared with the last economic outlook issued in October, with diversified export markets and improved competitiveness at the the root of the improvements. "Projected rates of expansion in 2012 of slightly over 3% (Lithuania and Estonia) and over 5% (Latvia) occupy the top positions in the EU," the report points out. "Well diversified export destinations, and the gains in market shares on the back of improved competitiveness helped sustain growth despite a much weakened rest of the Eurozone. Latvia appears to be on track to Eurozone accession in 2014, though for Lithuania this timing is as yet unclear."

Perspective I 13

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Despite slower-than-expected economic growth in the third quarter of 2012, the Turkish economy will likely return to stronger – but still moderate – expansion in 2013.

CHART:

slowed significantly in 2012, with the EBRD predicting the final figure for the full year will come in at 2.6%, the most damage being done in the third quarter with a disappointing expansion of just 1.6%.

However, in many ways the crisis has helped Turkey, which was (and still is to a significant degree) at risk from the huge current account deficit built up during 2011's domestic demand driven boom. The slowdown knocked confidence, which reduced demand for imports. Ankara has, therefore spent the year orchestrating a "soft landing," and has been highly successful so far, with monetary tightening throughout the year aided by the impact of high oil prices and weakening external conditions on investor confidence.

Russian collapse imminent!

"R

un! Run for your lives! Russia is about to collapse due to Russian President Vladimir Putin's mismanagement of the economy!" That was the essence of a piece in Newsweek called "The end of Putinomics"

by Owen Matthews on December 30, which predicted the imminent collapse of Russia.

[Groans] Here we go again... There is a long tradition of these "Russia is doomed" and "reforms are definitely over" pieces, the most famous of which was a report written by Edward Lucas, the then Moscow correspondent for The Economist (now an editor), in July 2001. Lucas held a press conference hosted by Vladimir Mau, the "Paul Krugman of Russia", on the release of the report that said the economy was about to fall into the abyss.

Russia and will have a significant impact on the economy, that's as far as it goes. With no debt and massive foreign exchange reserves, the Kremlin can easily cope, but at the same time it clearly still needs to do something about the importance of energy exports to the economy.

The chart also shows that consumer-related and corporate profit taxes together make up 58% of the federal budget revenues. If you want to look for signs of imminent collapse, then it would make more sense to measure the sales volumes of cars, iPads or foreign holidays. But of course those numbers have been shooting up for the last decade and most have already surpassed their pre-crisis peak. And that doesn't fit with the "imminent collapse" story.

Budget revenues structure, 2011

The region's two big economies outside the EU, Russia and Turkey, are predicted to have performed better than those in the EU in 2012, though problems remain for 2013.

The Russian economy, the EBRD notes, has not been immune to the impact of the Eurozone crisis. In 2012, the weaker global environment and lower investor and consumer confidence led to a significant slowdown in both external and domestic demand.

"Russian GDP growth is estimated at 3.5% in 2012 and expected to remain at around 3.5% in 2013 and the medium term, which is less than half of the rapid growth rate that Russia enjoyed in the years before the 2008-9 crisis," the EBRD says.

The country’s growth outlook, however, remains highly dependent on global commodity price developments, the EBRD says (oil and gas now account for nearly 70% of total merchandise exports and for around one half of government revenues). "The Russian government has recognised the need to reduce macroeconomic volatility by speeding up economic diversification, which in turn requires significantly improving

Embarrassingly, Mau flatly contradicted Lucas' conclusions during the conference. Even more embarrassingly, far from collapsing, Russia's economy went on to enjoy a four-year boom that transformed it into a more-or-less normal country – at least as far as living standards are concerned.

Matthew's (who is a personal friend) piece is a canard of the same ilk. The short version of the argument is: because of the production of shale gas in the US and elsewhere in the world, the government will lose the "roughly 20% of the state budget… its taxes constitute". Without this money, the subsequent cuts to social spending will provoke unrest and lead to the overthrow of the Putin regime. The only problem is that, as our chart shows, gas taxes account for not 20% of federal budget revenues, but just 3%.

The fallacy behind this piece is a very common gross simplification that every commentator is fixated on: that Russia is entirely dependent on energy and raw material exports. While it is true that falling gas prices are painful for

Income Property from Other state tax property

3%

Other resources Import duties taxes

1%

3%

Gas taxes

3%

5%

2% Corporate profit tax

12%

Personal income tax

10% Oil taxes Social tax

17% VAT and excises

Source: Ministry of economics

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bne February 2013

While expecting the worst, Latvian investigators may still be surprised by what they find on the Highway Investment books. According to bne enquiries, Highway Investment was not just a special purpose vehicle for the Naftogaz and Seadrill deals, but was already operating as a full-blown money-laundering platform at the time of the March 2011 tender.

Further, bne can reveal that the Latvian investigation is not the only criminal investigation with a bearing on Highway Investment. Ukraine has launched a crackdown on the activity of "conversion centres" – money-laundering operations that "convert" booked company funds into "black cash" via fictive contracts with fictive companies – and in doing so it has unwittingly spilled the beans on some of the forces behind Highway Investment.

Investigating Ukraine's Highway to Latvia

Highway robbery Highway Investment was set up in December 2008, with a certain Pavel Dvulichanskii as its director (holding power of attorney) and a bank account at Latvia's Trasta Kommercbanka, a bank that has been linked to Ukraine's former energy minister Yury Boiko.

Graham Stack in Zhitomir, Ukraine

L

atvia has officially confirmed that it opened a criminal investigation into Highway Investment Processing, a UK shell company that controversially sold a $400m drilling rig to Ukraine's energy giant Naftogaz Ukrainy in 2011 after purchasing it for only $248.5m from Norway's Seadrill.

huge mark-up prompted widespread allegations of corruption domestically and internationally, but Latvia is the only country until now to have launched a criminal investigation, prompted by Highway Investment having a bank account at Latvia's Trasta Komercbanka.

The criminal case could cause a major headache for Naftogaz and officials linked to the deal, just as the national gas company enters into a potentially crucial year with mounting pressure from Russia and a tightening domestic budget situation. And bne enquiries point to things being even worse than they first appear.

bne in June quoted sources in Latvia's economic crime department that an investigation into Highway Investment had been opened. Now there is official confirmation: according to Latvia's police spokesman on December 12, "in connection with the purchase

by Ukrainian company (Naftogaz subsidiary) Chornomornaftogaz of a jack-up drilling platform on March 1, 2011, on May 16 2012 the economic crime section of the main directory of criminal police of Latvia's state police initiated criminal investigation N11816009312 into the legalisation of funds obtained by criminal means."

In 2011, Highway Investment sold an offshore drilling platform to Ukraine's largest company, state-owned energy giant Naftogaz, for $400m, having purchased it for $248.5m from Norway's offshore driller Seadrill. The

Back in March 2011, the Highway Investment deal kicked off a Naftogaz spending splurge ostensibly aimed at increasing Ukraine's energy security by tapping reserves on the Black Sea shelf – but which may have achieved exactly the opposite: by saddling the strategically crucial, but financially challenged company with huge debts and mounting due-diligence questions.

The conclusions of the Latvian investigation as to the rights and wrongs of the initial March 2011 tender will thus bear on appraisal of all the company's subsequent procurement for the Black Sea drilling campaign – now at over $2bn and rising. Ironically, for a project that aims to secure energy independence from Russian gas supplies, the only international funding to date has come from Russia: in November, Russian stateowned bank Sberbank announced it had opened a $58m revolving credit line for Chornomornaftogaz.

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bne February 2013

Despite the company looking like a special purpose vehicle set up for the Naftogaz tender, bne was able to track down one payment made to Highway Investment completely outside of the Naftogaz-Seadrill deal: a small Zhitomir printing company Skerzo paid Highway Investment €270,000 for a second-hand offset press in November 2010. Skerzo subsequently took Highway Investment to court in 2011 when Highway failed to deliver the printer despite the money having moved abroad – violating Ukraine's foreign currency regulation laws.

Skherzo is owned by Oleg Karpeka, CEO of Zhitomir Cardboard Plant (ZKK). Karpeka co-owns ZKK with Lugansk mining magnate Igor Lisky.

A bne reporter, posing under cover as a British businessman, spoke to Dmitry Karpeka, brother of Oleg, about the payments made to Highway Investment.

To suspicious minds, the failed ZKK transaction looks like a typical fictive contract designed to move money abroad. But according to Dmitry Karpeka, the company really did order a printing press from a German company. Highway Investment, he explains, was used as a payment vehicle for the printer "to avoid the excessive Ukrainian paperwork and taxes". When the Germany company failed to deliver the goods, the money was returned to Highway Investment minus 20%, which the German company retained for having processed the order. According to Karpeka, the subsequent court case

Janus-faced Dvulichanskii But bne established that the Zhitomir cardboard plant (ZKK) had other relations with Dvulichanskii besides the non-resident company Highway Investment. Dvulichanskii – an unusual name which literally means "Janusfaced" – is not only the director of the UK company Highway Investment, but of another of ZKK's counterparties, this time a Ukrainian one.

According to a case brought against the company by the tax police in 2012, ZKK purported to have purchased paper waste and chemicals in 2010-11 from a

"The investigation points to Highway Investment being a sibling of other notorious platform companies run by Baltic banks and Ukrainian counterparties" with Highway Investment in Zhitomir was a mere formality required by Ukraine's foreign currency regulations – accounting for the fact that Highway Investment was represented at the Zhitomir court by ZKK's own chief engineer, Oleksandr Ergidzei, as shown in the document below.

Karpeka said that the Highway Investment director Pavel Dvulichanskii was a businessman from Lugansk, and when shown a photo from the Facebook page of a businessman of that name from Lugansk, he positively identified him. Karpeka said that Dvulichanskii was a connection of Lisky's and that the Highway Investment payment arrangement was Lisky's idea.

Lisky, however, told bne that this was not the case. "The transaction with Highway Investment was made by the printing company Scherzo, which is wholly owned by Oleg Karpeko, and to which I have no relationship at all," he told bne. Lisky said, however, it seemed to him that Highway Investment had indeed been a "platform for black market transactions." Lisky denied knowing anything about Dvulichanksii.

Lugansk private company Oriens PP, of which Dvulichanskii has been director since 2010. According to the tax police, these contracts with Oriens were fictive and solely for the purpose of tax evasion through reducing profits.

The tax service alleged in court that Dvulichanskii's company Oriens is "a member of a single financial-industrial group that was created for the provision of tax minimisation services, for the conversion of funds (into cash), and for the creation of VAT credits to reduce VAT payments." According to the tax police, Oriens is a fictive company with no staff, office or storage premises, and is one of tens of Lugansk fictive companies used in the conversion centre. Court records show that ZKK made payments to other companies alleged to be involved in the conversion centre as well. The tax service ordered ZKK to pay over $1m in back taxes. ZKK is contesting the claim in court.

Lisky told bne that the tax charges resulted from his support for the opposition party 'Front Zmin'.

However, according to the tax police, the conversion centre's customers

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comprise scores of industrial companies concentrated in East Ukraine, including for instance mines owned by the Sadovaya Group, listed on the Warsaw Stock Exchange. Court records show alone Dvulichanskii's Oriens to be accused of fictive transactions with over ten other plants besides ZKK. The fact that tax police name a Ukrainian company headed by Dvulichanskii, and receiving payments from ZKK, as part of a conversion centre points to Highway Investment also being part of the conversion centre – and likely receiving payments from other clients of the conversion centre besides ZKK. The Interfax Spark database shows that Dvulichanskii has had ownership stakes in two other companies – Ukrmagistral-2008 and Ukroptmagistralnik. Both companies are registered at the same Lugansk address and telephone number as Oriens.

Dvulichanskii himself denied any knowledge of the Ukrainian or UK companies to bne. His day job is as a broker of fencing and weightlifting equipment for Lugansk producer Dynamoblade. However the phone number provided for the Lugansk "fictive" companies in the state

bne February 2013

Akta Bank and the Baltics Interestingly, all the three Lugansk companies where Dvulichanskii has figured as director and/or owner, including Oriens, have had bank accounts at the same tiny Dnepropetrovsk-based bank, Akta Bank, according to court cases and bankruptcy announcements.

This suggests Akta Bank's links to Dvulichanskii and to the conversion centre uncovered by the tax police – as well as potentially to the UK company Highway Investment.

The Akta Bank connection to Highway dovetails with evidence pointing to Akta Bank's interaction with other nonresident companies with bank accounts at Baltic banks.

Akta Bank was established only in 2008

by Dnepropetrovsk businessman Vadim Ermolaev, owner of Alef Corporation, which has interests in real estate, agriculture and alcohol. Within a year of it being founded, then head of Ukraine's security service SBU Valentin Navailachenko named the bank with five others as being involved in largescale money-laundering in the form of conversion services. According to the findings of a National Bank of Ukraine (NBU) inspection of the bank in 2009, as leaked to weekly Zerkalo Nedeli in

"The criminal case could cause a major headache for Naftogaz and officials linked to the deal" register matches the mobile number provided for Dvulichanskii's work at Dynamoblade, indicating he may indeed be an employee of the conversion centre rather than a so-called "strawman" – those who stand in front of shell companies, masking the true owners. Ukraine's tax service is prosecuting the directors of other companies it claims were part of the same conversion centre, but it is unclear whether there are proceedings against Dvulichanskii himself.

2010, the bank had been selling around $10m and €5m in cash on a daily basis to the same four "individuals".

2010 the hryvnia suddenly slipped against the dollar, the NBU publicly said this was due to a spike in purchases of hard currency "by the population".

But NBU officials leaked documents to weekly Zerkalo Nedeli in late September 2010, apparently showing that Akta Bank – which had at the time only ten branches – had apparently sold a staggering $1.2bn of hard currency to the population for hryvnia in the first nine months of the year – which would make it astonishingly the second largest seller of hard currency to the population, after the country's largest bank, Privatbank, despite being only 60th largest in terms of assets.

If the Zerkalo Nedeli figures were true, where could Akta Bank have sourced the hard currency funds? Ukrainian court records suggest Akta Bank is linked to massive money flows from Baltic banks. From August to December 2010, according to court records, a New Zealand company Anglo Stand Ltd transferred €100m and $30m to a Ukrainian brassplate company in Kharkiv region, as "non-refundable financial assistance".

The New Zealand company transferred the funds from its account at Lithuania's Ukio Bank, to the Ukrainian company, Global Distribution AG's account at Akta Bank. According to the court records, the Akta Bank branch in Kyiv then paid out the entire €100m and $30m in cash to the director of Global Distribution over a period of four months, ostensibly to purchase agricultural produce. The tax police investigators identified this as a money-laundering operation.

Given that the NBU documents obtained by Zerkalo Nedeli show Akta Bank selling $1.2bn in hard currency for cash January-September 2010, the Anglo Stand Ltd. transfer may have been only one of over ten such transfers in the course of 2010.

Akta Bank both now and in the past has denied any connection to the activities of conversion centres and moneylaundering, and says all such reports are the result of paid smear campaigns launched by competitors.

Akta Bank's press officer said it was too early to comment on the ongoing Global Distribution court case and too late to comment on the 2010 Zerkalo Nedeli report.

In 2010, there were further revelations about Akta Bank. When in September

The Baltic connection is used by major operators of conversion centres to

bne February 2013

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In late 2010, early 2011, at the same time as the Naftogaz-Highway-Seadrill deal was in the making, Ermolaev was in talks in Kyiv with the Dzharti group over the privatisation of the assets of Nikopol Pipe Plant, a key supplier of non-rusting pipes for the nuclear power and aerospace sector, which had defaulted on a loan agreement with Akta Bank. In February 2011 – the same month as the Naftogaz tender – the Kyiv commercial court where Dzharti's daugher Viktoria is deputy chairman acknowledged Ermolaev's claim to the pipe plant assets and ordered their transfer to Ermolaev's structure Oskar, with Viktoria Dzharti's husband, Valery Omelchenko, taking a 25% stake in the company via his Austrian vehicle Wellmind Investment, as detailed by a Forbes Ukraine investigation.

hide from law-enforcement the link between the clients' wired funds to the conversion centre and the off-the-books cash that clients receive in return, minus commissions.

Friends in high places Akta Bank's owner, Vadim Ermolaev, is the business partner of a powerful Ukrainian political clan with links to the Naftogaz deals, which may account for Highway Investment being used as the vehicle for the controversial Naftogaz tender.

The clan was headed by Vassily Dzharti, a confidante of President Viktor Yanukovych and long-serving Party of Regions natural resources minister and governor of the Crimea – home of Chornomoreneftagaz – from 2010. Dzharti died suddenly in August 2011. Dzharti's protege Eduard Stavitskii at the time held the post of natural resources minister – until being made energy minister with oversight of Naftogaz in December 2012.

According to Esa Ikaheimonen, the former CFO of Norwegian offshore driller Seadrill, the company which sold the drilling platform to Highway

Investment in April 2011, the deal proceeded very quickly – with talks starting in December 2010 and the deal announced April 2011 – where the purchasing company could show it had the necessary funds at the ready.

This, together with the fact that the initial funds on the Highway Investment accounts may have been effectively untraceable since they originate from a multitude of transactions similar to the ZKK transaction, may account for using the company as a vehicle for the deal.

The investigation points to Highway Investment being a sibling of other notorious platform companies run by Baltic banks and Ukrainian counterparts, such as Tormex Limited, which a US court named as a money-laundering outfit for Mexico's Sinaloa cartel. This makes Highway an unusual choice of business partner not only for Naftogaz, but especially for a $19bn US-listed company like Seadrill.

Black:Dvulichanskii directorship Blue: banking relationship Red: money flow Grey: business partnership Yellow: influence

Ukio Bank

Anglo Stand Ltd. Boiko Group ¤100m, $30m

Trasta Komerc Banka

Dzharti Group

Global Distribution

Seadrill, Norway Ukropt-magistral, Ukrmagistral 2008

$248.5m

Naftogaz Ukrainy Akta Bank Pavel Dvulichanskii PP Oriens

$400m

HIGHWAY INVESTMENT PROCESSING LLP ¤0.27m

Other Lugansk 'conversion centre' cos.

I 17

ZKK, Skerzo

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bne February 2013

The Duma has never been popular with the masses, but the latest one vies for being the least popular of all. For the speedy issue of several repressive laws restricting the freedom of the rallies, NGOs and the Internet, it has been nicknamed "mad printer" and lately "the State fool" (a Russian play on words as "Duma" and "dura," or fool, are close).

One of the calls of this rally was to disband the Duma.

Photo: Mick Pankov

Suffer the little children Julia Reed in Moscow

N

ear the McDonald's on Pushkin square, small groups of people gathered ready for the march.

White ribbons on coats flew here and there. A group of eight girls in their early twenties obviously meeting up for the first time exchanged introductions: "We are all Katyas here except for Lena and Masha," the girls laughed.

Otherwise there was not a lot of laughter on the square, just excitement and the feeling of the tension of the moment.

The girls had joined an estimated 9,500 other people on January 13 in central Moscow to protest against the recently passed anti-adoption law that bans Americans from adopting Russian orphans. The law is widely seen as a tit-for-tat reaction to the so-called "Magnitsky bill" signed into law by the US Congress at the end of last year, which bans entry into the US of Russian officials suspected of involvement in the death of lawyer Sergei Magnitsky in 2009 while in prison.

Anyone who goes to such rallies recognises the faces of the usual

suspects as they approach the security.

Most of the regulars aren't media people; they are the activists, the actors behind the scenes responsible for the nitty-gritty of the event. Some 400 portraits of the Duma deputies

At the end of December, just days before the Russian response to the Magnitsky Act was signed, the opposition paper Novaya Gazeta on its website started collecting signatures against the American adoption ban and for dismissal of the Duma. Both initiatives have gathered over 100,000 signatures in just days, and the collection of votes continued at the rally. It was previously said by Putin that any initiative that gathers over 100,000 supporters, would be considered. Yet the procedure and the terms of how it can be considered remain unclear.

Pride before a fall The US adoption ban has angered many, even those not usually following politics, because it reminded the general public one more time just how dependent on the will of one man and how remote

"This law hurts the most vulnerable, the orphans in state homes, who cannot speak for themselves" who voted for the anti-adoption law with their names and a sign "Shame!" were printed out and carried aloft in a colourful display of anger. A lot of the names of the deputies are well known to the general public: they are the actors, singers, filmmakers and athletes who have leveraged their fame to become politicians. Given it was their names that got them their Duma seats in the first place, the protesters feel they are being let down by how the deputies voted.

from the day-to-day life and its issues the Duma and its deputies are.

The US adoption ban is regarded as just the latest (but perhaps the most outrageous) in a series of hastily drawn up and little debated laws that have been initiated by the Duma in its attempt to maintain the regime and preserve its pride. "This law hurts the most vulnerable, the orphans in state homes, who cannot speak for themselves," says Nadezhda

bne February 2013

Grigoryevna, 63. "I haven't been to any protests since last winter, but this time I couldn't stay at home." Grigoryevna accompanied her daughter Olga, 34: "I know me being here won't change anything, but I came just to show to the world that I'm not on the side of those who supports this law. That's the only thing I can do."

Tatiana, 54, complains that the statecontrolled TV channels will likely lie again and say that very few came today. "But look behind you, people and people everywhere," she enthuses.

"This Duma doesn't represent our interests. It doesn't understand how people live."

A woman carries a hand-made slogan saying: "A mother does not have a nationality" – one of many who feel that a family is better than a state home.

This notion, as common sense as it is, appears to be beyond the Duma. "We don't want them to use children in their games," says another protester.

"Shame! Shame!," shouted the crowd. No speeches were planned for the day, just the march. "It's regrettable that there will not be any speakers," says Yulia, 38. "A lot can be said about this law."

Dreary statistics It is not known exactly how many orphans exist in Russia. The statistics of the Department of Education from October 2011 say that there are more than 660,000 children without parental care. This number includes the so-called "social orphans" - the children who have biological parents but are not being looked after by them

Eastern Europe

due to poverty, alcoholism and other addictions, absence due to illnesses, divorce or imprisonment. Some 106,000 of these children are in full state custody in one of the 2,000 state homes in Russia.

In 2011 a total of 10,800 children were adopted. Some 3,400 of these went abroad, 965 of which were adopted

by Americans. Only 38 children with disabilities were adopted by Russians and 89 by Americans in 2011. The

I 19

improve the situation with orphans and to simplify the procedure for Russian nationals willing do adopt."

Many remain skeptical about any new measures. More money poured into the problem is unlikely to cure it; Russians aren't rushing to adopt just because they don't own the required size properties or because the adoption procedure is long, humiliating and drawn-out. No state benefits can cover the real costs of raising a healthy child,

"The Duma has never been popular with the masses, but the latest one vies for being the least popular of all" numbers for 2012 have not yet been released.

The numbers show that there are a lot more orphans in Russia than there are people domestically and internationally who are willing to adopt them. Given how slim the chances of being adopted are, especially for children with disabilities, the law clearly goes against the interests of Russian orphans. What can the Russian state offer its orphans instead?

There is speculation that it won't be long before a full ban on foreign adoption is introduced, since foreign adoption hurts Russian state pride.

On December 28, Putin signed a law saying that by February 15 measures should be outlined in order to "quickly

let alone a child with special needs.

In the environment where education and medical care are inadequate and in urgent need of reform, a ban on any foreign adoption can only be seen as cruel.

The anti-Magnitsky ban didn't damage the Americans it targeted. They can still turn to Ukraine, Kazakhstan or China for adoption, but it hurt Russia's own, most vulnerable, young citizens. Yet again in Russian history this "humaneating" law demonstrated that the country puts state rhetoric and pseudopatriotism before real people's needs, and that in Russia there remains a lot of state and not a lot of civil society.

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bne February 2013

off a string of Russian regions where the bank works that probably only known to the players of the board game "Risk" in the West. "We started in the east where the competition is much less: in the Far East, Kamchatka, Kalmykia, Sakhalin, Primorie, Yakutiya, Siberia and later moved into the North-West regions. Moscow was added quite quickly, but more as a source of deposits than of business.

Orient Express Bank builds from bottom up Ben Aris in Moscow

I

n the highly competitive Russian retail banking market, Orient Express Bank (OEB) has pulled off a neat trick. It has found a huge niche that is largely unoccupied and become one of the fastest growing banks in the country at a time when most of the foreign banks that bought into the market are pulling out because competition is so stiff.

How did OEB do it? By going into the regions and concentrating on the small cities and towns that the other Moscoworiented banks have ignored.

"We are strong in the smaller cities where there is less competition and we have been building from the bottom upwards over the last six years," says Sergei Vlasov, founder and CEO of OEB in an exclusive interview with bne. "We already cover over 1,300 cities in all the regions of Russia and we are more likely to be found in a village than in a big city."

Building from the bottom up is an obvious strategy given that everyone else has built from the top down, but it is not an easy one to pull off. The cost of setting up in every single one of Russia's 83 regions and catering to markets

where both the number of people and the average incomes are an order of magnitude less than in Russia's biggest cities means OEB has had to focus on efficiency, as well as charge significantly more for its services than the leading urban banks.

Russia's twin capitals of Moscow and St Petersburg have attracted the most

"We have been growing very fast, but the bank's business has grown faster than the capital. We have reinvested all the profits, but we needed to find partners to maintain our expansion," says Vlasov.

"We have another three years of fast growth ahead of us until we start to reach maturity, but we can still more than double in size."

Vlasov is no newbie to the retail business.

He cut his teeth as the manager of 1stOVK, a legendary bank that was the retail arm of Yeltsin-era commercial banking giant SBS Agro, which collapsed in the 1998 crisis. Rosbank, which belonged to oligarchs Vladimir Potanin and Mikhail Prokhorov, took 1stOVK over and brought Vlasov in as manager in 2003, where he built a post-crisis retail juggernaut, before the whole group was eventually sold to Societe Generale in 2007.

While like almost everyone else in the consumer credit game the bank is present in all of the 35 Russians cities with populations over 500,000 people, the

"We are more likely to be found in a village than in a big city" attention. The two biggest cities in Europe with a combined population of over 16m, they are together bigger than most Central European countries and average incomes are several times higher than in Russia's far-flung regions. But by the same logic there are almost no banks other than the state-owned retail giant Sberbank in those same regions. "In most regions there is only us and Sberbank and we share the market 60-40," says the ebullient Vlasov, who goes on to rattle

bulk of its 700-odd branches are in cities of 100,000 or less, with 60 branches in cities with 30,000 people or less.

Put another way, the bank is already present in all the big cities, but has only penetrated a third of the cities of 50,000100,000 and only 8% of Russia's cities with 30,000 or less people. Even if the richest Russian markets of Moscow and St Petersburg are saturated with banking services, OEB has only just started to cut

bne February 2013

into the much larger market made up of small cities and towns in the regions and is on its own in most of these places.

All this activity has led to some impressive growth figures. Since 2008, the loan portfolio had grown from RUB24.2bn ($1bn) to RUB147.1bn ($4.9bn) by the end of the first half of last year – a cumulative growth rate of 67.4%. At the same time, deposits have grown even faster as the locals move their savings out of the staid behemoth Sberbank and into the shiny and userfriendly branches of OEB that have opened in their home towns. Deposits have grown from RUB18.5bn ($771m) to RUB134.3bn ($4.47bn) – or a compound average growth rate of 76.3% – over the same period.

The boon of having a niche to yourself is fast growth can be managed without compromising on the quality of the lending. The non-performing loan ratio to total loans was 5.7% in 2008 and is now only 6.8% as of July this year, or RUB10bn, which is on a par with the sector as a whole. However, thanks to the premiums that OEB can charge, its equity has grown at an annualised rate of 56% over the last five years and its return on equity by a whopping 34% as of the end of 2011, which is not only one of the best in Russia but seventh best of the world's top 1,000 banks, based on the results of The Banker's annual ranking, says Vlasov.

Investor interest piqued The bank's boasts of being number one in auto-loans, where OEB has sewn up the second-hand car loan market, and having the third largest retail network in Russia (if you include points of sale in addition to branches) has piqued the interest of investors. OEB already counts Baring Vostok Capital Partners as a shareholder, Russia's most successful private equity fund that owns 30% of the bank, but recently added Russia Partners, another top flight Russiadedicated fund, which bought a 6.9% stake for $160m at the end of October.

Amongst its other shareholders the bank counts the World Bank's commercial arm, the IFC, which owns 13.9%, and

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End of an era in Russian banking

bne GE Money Bank, which kicked off a wave of foreign acquisitions in Russia's banking sector, is reportedly up for sale, which if true would mark the end of an era in the development of the country's financial sector. Back in 2006, the purchase of Delta Bank by the US retail banking giant kicked off a frenzy of bank purchases in Russia that caused their value to soar – a development that spread to Ukraine and Kazakhstan.

General Electric, the owner of GE Money Bank, is now reopening negotiations with potential investors after dropping a tentative plan to exit last summer, local media have reported. One of the possible suitors mentioned is the enfant terrible of Russian banking, Igor Kim, who has already bought Expobank from Barclays, which was one of the first foreign players to quit Russia after having bought at the top of the market in 2007.

Kim has also been snapping up other niche banking assets on the cheap since the 2008 global crisis.

GE Money Bank has yet to make a formal offer, reported RBC Daily, nor is it known if Kim is still interested in the asset, but speculation is rife following an offer to him from Belgium's KBC Group to take Absolut Bank off its hands. Kim has reportedly expressed interest and offered RUB8bn ($260m) against an asking price of RUB11bn.

Even if nothing comes of GE Money Bank's attempt to leave Russia, the reports highlight how foreign universal banks with a retail strategy are finding it increasingly difficult to work in Russia. The same is true for investment banks, highlighted by the sale by Stephen Jennings of his remaining stake in Renaissance Capital to Mikhail Prokhorov in November.

Last year, asset growth rose to 25% or so. While that's still clearly healthy, the big difference is that the state-owned giants Sberbank and VTB have become very aggressive and are using their institutional advantages to grab market share. That has seen foreign banks leaving in droves over the past couple of years; only those banks like Societe Generale, Raiffeisen and Home Credit Finance Bank, which bought into the sector in the early naughties, are still in the game and likely to survive.

Increasingly, Russian banking is just for Russians.

Igor Kim, the wunderkind of Russian regional banking that was behind Ursa bank, which was eventually merged with commercial bank leader MDM Bank.

The extra capital will be used to continue expanding its loan portfolio next year: at the end of the first half of this year there was still a RUB13bn ($430m) gap between the loan and deposits portfolios that needed financing. Indeed, Vlasov

says the bank will probably be back in the market in the new year to raise even more capital. "We have been growing very fast, but the bank's business has grown faster than the capital. We have reinvested all the profits, but we needed to find partners to maintain our expansion," says Vlasov. "We have another three years of fast growth ahead of us until we start to reach maturity, but we can still more than double in size."

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car that was losing money, 80% of our sales were coming from the Gazelle, which has a 78% market share in its class," says Andersson, who says the decision was not obvious at the time.

Russian automaker learns to run like a GAZelle Ben Aris in Nizhny Novgorod

S

koda Auto, the Czech subsidiary of German car giant Volkswagen, launched production of its aptly named Yeti sports utility vehicle (SUV) at GAZ's facility in Nizhny Novgorod, on December 6 as the iconic Russian car plant takes another step on the road to recovery.

GAZ (which stands for the Gorky Automotive Plant) was effectively bankrupt when Bo Andersson was hired in 2009 by the plant's owner, oligarch Oleg Deripaska. "It was a nightmare – we owed $250m to suppliers. But within ten months we managed to pay them all back," says the former Swedish brigadier general who remade himself as a car man working for General Motors.

In the last three years, Andersson has put together a string of deals that has put the huge plant back into the black and helped to cover the cost of maintaining it – the second largest in Europe – and provide training and employment for the staff. The company

earned $260m of net profit in 2011, the best in GAZ's history.

Andersson's first decision was to close the production of the Volga 3111, Russia's "other" passenger car that competed with the ubiquitous Lada in

Gazelle production this year is expected to reach just over 100,000 units, but this is far too little to occupy the plant's massive capacity, which was first set up in a deal between Lenin and Henry Ford to make trucks under licence. So Andersson has turned the plant into what is in effect an automotive industrial park; in addition to Volkswagen, it has attracted General Motors and Daimler, which also have production lines there.

"In Russia, it is still cheaper to renovate than it is to build greenfield," says Andersson, who admits that 2m square metres (sqm) of the total 3m sqm plant is still standing unused today.

The Skoda facilities are one of the biggest projects to make use of GAZ's floor space. Skoda's second Russia-based facility, the Czech maker of cars has signed a contract that, rather than create a strategic joint venture, gives it use of the space workshop – a building that used to house the Volga's production – and access to GAZ's 52,000-strong workforce where many employees are third generation car-workers.

At the opening ceremony of Skoda's new line on December 6, Skoda CEO Winfried Vahland said: "Russia is our

"We were putting 80% of our effort into a car that was losing money" Soviet times. Following the advent of consumer loans in Russia, both cars have all but disappeared from Russia's roads as the population switched en masse to the more prestigious foreign brands. Instead, Andersson focused all the effort into GAZ's flatbed truck the Gazelle, a Light Commercial vehicle (LCV) which has been a runaway success since its launch in 1994. "We were putting 80% of our effort into a

third-strongest sales market worldwide and our number two in Europe as it is, and we intend to grow further in years to come, which is why we are resolutely extending our model offensive in this country and expanding local capacity further."

Skoda plans to increase its worldwide production to 1.5m units a year by 2018, with the Russian production rising to at

bne February 2013

Eastern Europe

"Rather than create a JV, Skoda gets the use of a building that used to house the Volga production and access to GAZ's 52,000-strong workforce"

least 300,000 over the same period. All in all, VW will invest €16.7bn worldwide in the next three years, of which €840m is earmarked for Russian operations, according to VW management board member Michael Macht.

It is a deal that benefits both sides.

VW can slot into the infrastructure GAZ offers, while Andersson's staff are trained to use state-of-the-art equipment and get used to international best practices; and Skoda has invested heavily into its production line in Nizhny Novgorod to create one of the most modern body shops in Europe.

That one's mine Andersson is pleased with the deal that fits with his self-confessed entrepreneurial approach to getting GAZ back on its feet. Another change he made was to introduce pre-payments for all the Gazelles and he tells his workers that each car they make already belongs to someone in an effort to concentrate them on keeping quality high.

Gazellle is just about to bring out a new model, its third, the Gazellle Next, and a few were sent out last week to select customers to test drive. The Gazelle has several things going for it, but the main selling point is the price tag of RUB1m ($30,000) for the Gazelle Classic, which is almost half that of its foreign brand competitors. Almost as important is that 85% of the components are Russian-made. Keeping costs low is the core of Andersson's strategy, who says he only invests 1.5% of revenue into his own production against the industry standard of 6-8%. "It means our customers can fix and maintain the vehicles themselves, as parts are widely available," says Andersson, who is well aware of the difficulties as he used to

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bne:infrastructure

be head of purchasing of components for General Motors.

Finding components is a major headache for the foreign manufacturers working at the GAZ plant. The Kremlin forced a new investment deal on the major foreign manufacturers last year where they committed to increase the share of Russian-made components from the current 30% to 60% over the next five years in exchange for holding down import tariffs on parts in the meantime.

Andersson has taken advantage of this too, setting up a joint venture at the plant with Belgium's Bosal, a world leader in the production of mufflers and catalytic converters, which went into production this year. "We found that the only component we could source in Russia that was cheaper than an import was palladium [supplied by Norilsk Nickel located on Russia's Artic northern shore] that is used in catalytic convertors," says Andersson.

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

The joint venture will supply exhausts for both the Gazelle and the Yeti and goes part of the way to fulfilling VW's obligation to source more parts in Russia as well as making GAZ some more money in the process.

Register and sign up for the list here: www.businessneweurope.eu/ users/register.php

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Photos © www.etalongroup.com

Russia's Etalon builds for the middle

the size of Etalon's projects. "The regions are growing fast, but the other big cities have populations of about 1m people and the demand is for about 100,000 square metres (sqm) a year, which is too small for us," says Evdokimov.

according to Evdokimov. Today, these five-storey houses (the tallest you can build without installing a lift) are in terrible repair and widely derided, but they still sell for "astronomical" prices, says Evdokimov.

Etalon's "Golden Bay" development in St Petersburg is typical: it was finished last year and has over 200,000 sqm of residential space. In Moscow, the company has just completed the 140,000 sqm first phase of the 1m sqm Emerald Hills project in Krasnogorsk in the Moscow region, which will cost about $2bn to complete by 2016. "All our developments are outside of the centre of the city as we are building the second and third bands of the city, extending the suburbs," says the ebullient Evdokimov who spends much of his time travelling to places like London and New York to meet with investors.

Punters are willing to pay upfront if they know they are going to get a good-looking modern apartment and

BRICKS & MORTAR:

Financing the dream The secret to the company's success is it gets its customers to finance the building work by paying for the apartment before it is finished.

Ben Aris in Moscow

V

iatchslav Zarenkov must have building in his bones. Once a construction worker himself, Zarenkov founded Etalon Group, Russia's leading residential developer, 25 years ago in St Petersburg during Perestroika, making him a pioneer of Russia's private sector. Today Etalon continues to go from strength to strength and has become a favourite of investors looking for exposure to Russia's emerging middle class.

Etalon, which in April 2011 listed on the main board of the London Stock Exchange raising $575m, is the biggest residential developer in the north west of Russia. It concentrated first on Zarenkov's hometown of St Petersburg, but more recently has moved down to work in the Russian capital. "We offer higher class accommodation at affordable prices," says Anton Evdokimov, Etalon's chief financial officer, in an exclusive interview with bne. "We build in the 'comfort class' that appeals to the middle class. They are not interested in marble entrance

halls, but want practical and comfortable places to live."

It is a market segment that Etalon has more-or-less to itself, as its competitors either build cheap residential buildings

To the western ear this sounds incredibly risky and indeed there have been a number of scams where punters bought apartments in the planning stage only to see the developer "go bust" and their money disappear before a single brick was laid. Amazingly, Etalon

"Would-be homeowners trust Etalon to keep its word and finish the building" for the lumpenproletariat or the highmargin 'elitny' buildings for oligarchs and their peers.

And Etalon builds big. The company is known amongst analysts for its good margins and high internal efficiency, but this means it has to stick to the two Russian capitals of Moscow and St Petersburg – the biggest and second biggest cities in Europe respectively – as they are the only metropolitan areas that have the scale of demand to match

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doesn't even offer discounts on their unmade apartments, which sell at the same market rates as flats that actually exist already.

The reason this pre-paid model works is two-fold. First, almost 70% of residential space in the big cities consists of the so-called Khrushchyovka, or prefabricated panel buildings introduced by Nikita Khrushchev in the 1960s, which were quick to assemble and introduced to meet a dire housing shortage,

Eastern Europe

And the company takes no risk, as the deed is only transferred after the last payment is made. Evdokimov says that usually they can sell 80-90% of the apartments in a complex before it is completed. "There is no true mortgage in Russia yet," says Evdokimov. "It may say 25 years on the ticket, but the actual duration of mortgages in Russia is three years: what people are doing is taking out

"The secret to its success is it gets customers to finance the building work by paying for the apartment before it is finished" they even get a say in some aspects of its construction while it is being built. More importantly, would-be homeowners trust Etalon to keep its word and finish the building, because it has been in business for 25 years and has never reneged on a deal.

The second reason is Etalon's apartments are easy to finance.

Mortgages took off in about 2010 and have been doubling in volume every 18 months or so to account for about 35% of all apartments sales, according to VTB Capital. However, mortgages only account for about 10% of Etalon's sales. "We do no due diligence on the customers or any checking of any sort.

As long as they can make the downpayment and keep up the instalments, then we will sell them the apartment," says Evdokimov.

In the topsy-turvy world of Russian finance, ignoring mortgages and due diligence is actually an advantage.

Banks carry out stringent and invasive checks on potential borrowers, but the main problem is that most Russians' spending power is way beyond their official income: most people moonlight or have a secondary source of income – both legal or illegal – which can't be taken into the account by a bank when calculating the maximum size of a potential mortgage loan. But with Etalon the only criteria in play is whether you can make the payments.

a bridging loan to move into a new better place and then sell their old apartment, which they use to pay off the loan."

To bank its good reputation Etalon has set up a very strong sales network that operates 10 representative offices throughout the country and another 30 agents.

At first glance, the list of their locations looks bizarre, as it includes several cities that are quite literally in the middle of nowhere: Mirny in the midst of the permafrost of Yakutiya, Sugurt

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in the western Siberian tundra, Norilsk on Russia's frozen northern coast, and Magadan, the one-time centre of the Gulag Archipelago in Russia's icy far east. However, Evdokimov explains that these cities make perfect sense in the Russian context: Etalon set up real estate sales offices in these terrible places because everyone working there plans to leave. These regions also happen to be amongst Russia's richest thanks to their mineral wealth. "They are all mining towns of one sort or another – Mirny is diamonds, Surgut is oil, Norilsk is nickel – and people go there on 10- to 15-year contracts. But in the last five years, they start to think about what they are going to do next," says Evdokimov.

And given the choice, most people in Russia want to move to one of the two big cities: a study by the World Bank a few years ago found the population of Moscow would double if Russians were given the means to live where they wanted. However, as per-capita incomes continue to rise for more and more people, that dream is coming true. Evdokimov says that over the next three years the company plans to more than double the volume of buildings and commission 400,000 sqm in St Petersburg and 800,000 sqm in Moscow.

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funds are trying to reduce their exposure to countries like Italy and Spain – and the sheer size of their bond markets means that even a small movement out can wash into other European bonds," Mark Allen, the International Monetary Fund's (IMF) senior resident representative for CEE, told a conference in Prague organised

by Wood & Co at the end of November.

"Hungarian default swaps have fallen from 700 basis points (bp) to 250bp – that hardly reflects improved fundamentals, but does reflect the amount of money sloshing around."

Another banner year for CEE bonds?

Nicholas Watson in Prague

2

012 was a record-setting year for global bond funds, pulling in over $470bn of cash, according to EPFR. But while emerging market bonds in general are expected to continue performing well this year, the outlook for Emerging European bonds is more uncertain.

Emerging market sovereign debt returned nearly 16% last year, corporate high yield almost 17%, and local currency bonds about 14%. bne's 2012 Fund Survey, published in August, showed just how well Central and Eastern Europe (CEE) bond funds had performed over the previous 12 months: the winner of the "bne Best FixedIncome Fund 2012" was Erste Asset Management's "ESPA Bond Emerging Markets Corporate" fund with a return of 8.01% between July 1, 2011 and June 30, 2012. Compare that with winner of the equity category, which was Erste's "ESPA Stock Istanbul" fund with a negative

return of 0.21%. Other bond funds also performed solidly, including Pioneer Investments' "PIA Central & Eastern Europe Bond" fund, which returned 9.2% in the first six months of 2012.

The reasons behind the emerging market bond rally aren't hard to pinpoint. Emerging markets' economic

agencies) proved slow to realise the major changes in the global economy that the 2008 crisis and now the Eurozone crisis have wrought.

Capital inflows into emerging market bond funds have been growing since 2010, contributing to a fall in sovereign spreads across the board, but this

"Developed market bonds are trading at bubble levels; by contrast, conditions in emerging market debt are at the opposite end of the spectrum" fundamentals are much stronger than those of developed markets – five-times faster growth, ten-times less debt, and control of 80% of the world’s foreign exchange reserves. At the same time, their bonds were badly mispriced at the end of 2011 as investors (and the rating

trend has definitely picked up in the last year or so as the Eurozone crisis deepened and the disparity widened between the slow-growth, debt-laden economies of the rich world and the healthy emerging market economies.

"Those that manage European bond

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There's been a consequent increase in bond issuance from Emerging European countries trying to take advantage of the lower rates. Poland issued the equivalent of almost $12bn of foreign currency debt in 2012, with the latest coming at the end of November, which was a $750m reopening of 12-year euro-denominated notes priced at 135bp over mid-swaps, compared with the 143bp spread when it sold the original €1.75bn tranche just a month previously. Poland's total issuance trailed only China's $30bn among emerging market peers, according to data compiled by Bloomberg.

Other sovereign issuers include Slovakia, Serbia and Slovenia, while the rally is tempting other, even more troubled, names such as Belarus, Ukraine and Hungary.

Russia was a heavy local currency bond issuer last year as the government prepared to give foreign investors unfettered access to the country's sovereign and corporate ruble bond market by hooking up to the international settlement system Euroclear. That finally happened in November. VTB Capital predicts $50bn will flow into Russian bonds in just the first few months following the move.

Currently, foreign investors account for about 4-5% of government and corporate bonds outstanding, well below the 15-20% held by foreigners in the bond markets of Russia's BRIC peers.

A harder year The question for investors is where we

go from here. Jan Dehn of Ashmore Investment Management, writing for the Financial Times' beyondbrics site, pointed out that the general trend of emerging market countries converging with richer countries remains intact and actually is still in its relative infancy.

Furthermore, even after last year's rally, emerging market fixed income is still cheap by historical standards.

"Sovereign dollar bonds – on average an investment grade asset class – today trade at 280bp over US treasuries compared to 165bp prior to Lehman

the same can't be said of Emerging Europe.

The IMF's Allen predicts the Baltics should do best in the region in 2013, followed by non-EU Southeast Europe, Central Europe, then EU Southeast Europe – but all four areas are heading for a slowdown. "There could be a pickup in the second half of the year, but that's predicated on things going right and uncertainty dissipating," he said.

The key events that need to go right were the US managing to piece together a deal to prevent "falling

"If we need to strengthen a bigger country like Italy, Europe must do it in a more efficient way or we're all doomed" [Brothers' collapse]. Emerging market corporate high yield spreads offer even more value at 640bp over compared to 270bp before Lehman," Dehn said.

Developed market bonds, he said, are trading at bubble levels; by contrast, conditions in emerging market debt are at the opposite end of the spectrum.

"Today’s emerging market investor is mainly local, institutional, and longterm oriented. Emerging markets are one of the few remaining sovereign bond markets without direct central bank manipulation of prices. External debt/GDP has declined steadily from 60% in the 1980s to 25% today, while it has increased to 250% in indebted developed nations over the same period," Dehn said. "A rapidly expanding yet still underfinanced corporate sector renders emerging market corporate bond supply extremely price elastic, constrained in effect by demand, which is growing only as fast as perceptions change about the asset class."

Yet while emerging market economies in Asia, the Middle East and North Africa, and South America are expected to continue growing solidly this year,

off the fiscal cliff", which it did to some extent; Europe making further progress in sorting out the debt crisis; and emerging markets avoiding a hard landing of their economies. "I don't have a very encouraging story to tell – it depends on lots going right in the Eurozone," he said. "I can't see very bright spots, but the risks are less than before."

The problem that afflicts Emerging Europe more than other emerging market regions is, of course, its reliance on the rest of Europe and thus its proximity to the crisis. Miroslav Singer, governor of the Czech National Bank, told the same conference that the main risk to the region is an escalation of the crisis in the Eurozone. While he said he's optimistic, the issue is still a source of tension. "If we need to strengthen a bigger country like Italy, Europe must do it in a more efficient way or we're all doomed," he said. "Spending €150bn to sort out Greece's €200bn problem does not strike me as a very efficient way of managing a debt problem."

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who uncovered it but died in prison under suspicious circumstances, this case is a $230m Russian tax fraud that has become a major source of international embarrassment for the Kremlin because of mounting evidence that prominent officials within the Interior Ministry, tax offices and the judiciary were involved.

Photo © balticfeatures

Baltic banks at the "Hearts" of Ukraine graft Graham Stack in Kyiv

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here may be fewer bigger followers of Heart of Midlothian FC in Ukraine than Zhitomir local Anatoly Rupeta, but his enthusiasm for the Scottish football club is waning.

Rupeta is facing a lengthy jail sentence after being stitched up, as he claims, by a gang of Ukrainian money-launderers operating via Lithuanian bank Ukio Bankas, owned by Valery Romanov, who also since 2005 has owned the venerable Edinburgh team.

"Hearts were always my favourite Scottish club because they have the same colours as Zhitomir. I don't know how directly Romanov himself is implicated in my problems, perhaps he is too involved at Hearts to follow what is going on at his bank, but I call on him to prevent a terrible miscarriage of justice," Rupeta tells bne in a cafe in his native Zhitomir, a regional centre of 250,000 people about two hours drive from Kyiv.

Rupeta is facing a 10-14 year jail sentence if found guilty on what he says are trumped-up charges. But despite four years of legal proceedings now drawing to a close, the spruce 54-year-

old looks younger than his age, and is calm and collected when talking about his case – and curious to see what a Brit makes of it. As befits a former bank manager, he has put together an impressive array of documents and testimony supporting his arguments.

Rupeta's account raises questions about the real business activities of the East European businessmen who have invested in British football. It also dovetails with a body of evidence that home-grown Baltic banking is linked to dirty money from the former Soviet countries. These questions became more pressing after the arrest of Romanov's colleague both in British football and in Baltic banking, Vladimir Antonov, on asset-stripping charges in 2012. Lithuanian authorities nationalised Antonov's bank Snoras due to major regulatory violations in 2011, shortly after Antonov had purchased the English football club Portsmouth. Lithuania also in January became the latest country – following Switzerland, Latvia and Cyprus – to open an investigation into how its banks might have been involved in the "Magnitsky case". Named after the lawyer

Press-ganged Rupeta says he fell foul of the Ukrainian money-launderers in 2007. But he has only now dared to speak up after the alleged ringleader of the group in Ukraine, banker Ruslan Demchak, was arrested on money-laundering charges in September 2012. In January , the National Bank of Ukraine withdrew the license of Demchak's small lender RD Bank, which is now undergoing liquidation.

Demchak has said his arrest was politically motivated due to his decision to run as an independent candidate in the October parliamentary elections. His press secretary refuted all allegations of money-laundering and any involvement in bringing charges against Rupeta.

Rupeta says his troubles started when he stumbled across the money-laundering operation in late 2007. He says the gang, unknown to him, were using a bank account opened for the small firm where Rupeta held the post of director – with tens of millions of dollars pouring into the account, wired in instalments by a UK shell company from an account at Romanov's Ukio Bankas.

But when a member of the gang died in a car crash in December 2007, the scheme also skidded off the road, because the widow inherited large amounts of money "belonging" to the money-launderers.

Demchak came to Rupeta personally, relates Rupeta, and told him he would use his connections in law enforcement to fabricate a criminal case aimed at freezing the widow's assets, and this would include bringing criminal charges against Rupeta as well, as director of a company involved in the scheme.

Sure enough, the Ukio Bankas client – Corpmark Impex LLP – filed a complaint

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to the police against Rupeta, and the police immediately brought charges.

The complaint alleged Corpmark Impex, despite having signed no contract, had wired $6m to Rupeta's firm as 100% advance payment on a shipment of granite he had promised to deliver, but then failed to.

Rupeta says he admires British justice as much as he does British football, but that Corpmark Impex LLP, registered in the quiet Hertfordshire village of Elstree, snuggled between parish church and vicarage, may as well have been a resident of the murkiest Caribbean tax haven, such was its disregard of law enforcement.

Experts agree. “It does look like the case was stitched up. The complaint itself is nonsense and facts cited have been clearly tortured to force the semblance of a criminal allegation,” says lawyer Valery Fedichin of Kyiv law firm OMP, who examined the complaint independently. "The pattern of payments looks instead like a classic money laundering scheme, using the Ukraine company as part of a complex scheme of shell companies," says anti-money-laundering expert Saskia Rietbroek of AML Services International, who examined payment documents connected with the case.

The wheels of justice in Ukraine grind slowly but inexorably. Rupeta is expecting sentencing this year on charges of major fraud, which brings a prison sentence of 10-14 years. Ukraine courts convict in 95% of cases. This despite the fact that the mysterious Ukio Bankas client, Corpmark Impex, that brought the charges against Rupeta has since been dissolved.

Demchak and his top managers – the people who Rupeta claims stitched him up – are themselves now in custody facing money-laundering charges. "I don't know who was the mastermind behind the scheme – the Baltic banks or Ukrainians – but I believe Romanov might help if he wanted," says Rupeta.

Romanov's investment company Ukio banko investicine grupe (UBIG) had not responded to a request for comments at the time of going to press.

Central Europe

In and out…

Rupeta, a former bank manager, has had plenty of time during the years of legal proceedings to analyse what exactly had been going on. According to his enquiries, backed by documents seen by bne, the scheme functioned thus: Three non-resident shell companies – Corpmark Impex from the UK, Geraldic SA from Panama and Bridgemax Ltd from New Zealand – channelled hard currency funds to several small local Zhitomir firms, including Rupeta's. Both the British company and the Panamanian company had accounts at Romanov's Ukio Bankas, while the New Zealand company had an account at Latvia's Trast Komercbanka.

The small local companies stood as guarantors for a $2m credit line at a local bank, held by the bank's own head of foreign currency operations – the man killed in the car crash in December 2007. As the manager drew down the funds in cash apparently for his "personal needs", the guarantor firms topped up the account using the funds they were receiving from abroad. The cash funds drawn down by the bank manager were then in fact distributed by road to the clients of the moneylaundering platform.

In Ukraine such an operation is called a "conversion centre". The term refers to the conversion of booked company funds to off-the-books cash. Companies

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convert, the Ukrainian word for "envelope", the medium for such payments.

The total annual volume of the market in such "conversion" is around $7bn, according to an analysis by Ukraine's security service SBU that was leaked to the press in 2010.

According to Vladimir Lysenko, professor at Ukraine's national tax service university, "conversion centres are mostly directly organised by Ukrainian banks." Baltic banks play a key role in such operations by circulating hard currency funds in and out of Ukraine via shell companies. According to Rupeta, a total of $57m in cash was transferred from the Baltic banks and paid out in cash via the scheme over a period of one and a half years. "The operation was completely illegal," points out Rupeta, "since there were no foreign trade contracts to back the hard currency transfers from abroad, as is required by law."

But the money-launderers' contacts in law enforcement ensured a blind eye was turned, alleges Rupeta.

Demchak's scheme is not the only one where funds channelled from and to Ukio Bankas feature prominently.

According to legal proceedings brought in 2012 in Ukraine, over the space of four months from September to December 2010, another New Zealand shell company, Anglo Stand Ltd, wired

"Hearts were always my favourite Scottish club because they have the same colours as Zhitomir" wire payments under fictive contracts to firms run by the "conversion centre", and get the money returned in cash, minus commission, on average 10%.

The goal of the operation for its clients is tax evasion, by reducing profit tax through inflating company expenses while creating fraudulent VAT credit, and then using the cash received in return to pay salaries off the books, thus avoiding payroll taxes. As such, "conversion centre' is often shortened to

a breath-taking €100m and $30m to a small firm in Kharkiv, Ukraine from its bank account at Ukio Bankas. The funds were wired on the bizarre basis of an "agreement on non-refundable financial assistance" – ie. a generous Christmas present from the New Zealand firm to the Ukrainian. The director of the Kharkiv company then cashed the entire sum from its account at small regional bank Akta Bank, ostensibly for purchase of agriculture produce.

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While court records only detail this single transaction, the scale of this operation may have been tenfold greater. According to documents leaked to the press by Ukrainian National Bank officials in

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$1bn from their accounts in FS Bank to accounts at Ukio Bankas, Trast Komercbanka and Kyrgyzstan's Asia Universal Bank – the latter a bank that Kyrgyz authorities nationalised in 2010

"Lithuania became the latest country to open an investigation into how its banks might have been involved in the Magnitsky case" 2010, the same small regional bank, Akta Bank, had already converted over $1bn of hard currency funds into cash between January and September 2010, making the total for 2010 close to $1.5bn.

It is not clear how much of this total was transferred through Ukio Bankas.

According to Ukio Bankas, "As far as we know Ukrainian laws currently don’t include 'tax crimes' as a predicate offence [for money-laundering]. Ukio bankas is neither claimant nor respondent in these cases."

"We assure that Ukio bankas strictly follows the law (including anti-money laundering laws) of the Republic of Lithuania and EU Directives in its everyday operations. The bank‘s operations are regularly supervised by the authoritative state institutions.

We also cooperate with state law enforcement authorities as required," Ukio Bankas added. … and round about There is also visibility on the reverse side of the operation – moving funds back out of Ukraine to the Baltics, and then on into the international financial system.

In 2009, the head of Ukraine's security service SBU accused another small Dnipropetrovsk bank, FS Bank, of hosting conversion centres that had moved over $2.5bn out of the country illegally in preceding years, including to Ukio Bankas.

According to the corresponding court case documents, between January 2007 and August 2008 three UK shell companies – Technoline Service, Winsboro and Dreamlux – wired over

due to money-laundering suspicions and balance sheet holes.

The UK companies declared the funds to be the repatriation of their return on investment. The "return on investment", however, came from the sale at face value of what in fact were worthless local securities – a notorious scam for shifting funds from one company to the next. The securities were sold to a cluster of other UK, US and Ukrainian companies all with accounts at FS Bank, where it is to be assumed the wired payments from clients of the conversion centres had accumulated.

What happens to the dirty Ukrainian funds after reaching the Baltics?

Luckily in 2010 the Belgian Financial Intelligence Processing Unit (CTIF), Belgium's anti-money-laundering watchdog, flagged up suspicious money flows that had passed through a "Belgium bank" from a "East European" bank. Two respected Belgian media outlets quoted sources in CTIF that the banks in question were Belgium's ING and Lithuania's Ukio Bankas. Ukio Bankas in turn confirmed at the time that it had been queried about the payments.

According to the CTIF report, the "East European bank" had two accounts at the Belgian bank for correspondent banking. "They were used to transfer money from various offshore companies, customers of this bank, to various counter parties across the world." Around €1.4bn was transferred via the correspondent accounts in 20082009 to a variety of tax havens across

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Central Europe

the world, in an operation involving a total of 475 shell companies.

"There was little or no information available on the articles of association or these companies' activities… CTIF's analysis showed that several of these companies were known for serious and organised tax fraud, corruption, embezzlement, fraud and organised crime,” reads the report.

The money was transferred in such a way using a series of intermediary companies and alternately regrouping and splitting the funds to make it difficult for the bank in Belgium to determine their origin. "The bank made sure they could conceal the nature of the money," concludes the report.

From grey to black The phenomenon of conversion centres may account for the bulk of the dirty money between Ukraine and Baltic banks on an annual basis. Tax evasion sounds quite harmless, considering the high tax rates and bureaucracy in Ukraine. But the enormous grey international financial flows generated create a channel perfect for laundering the proceeds of crime and corruption.

Moreover, on a local level the work of conversion centres involves billions of dollars in cash buzzing around Ukraine's pot-holed roads – and none of it recoverable by legal means. This makes their activity the preserve of serious organised crime. And given the improved technologies at the disposal of Ukraine's tax police, none of this would be possible if law enforcement agencies were not paid off or cut in. Thus conversion centres are a key intersection of the state and mafia.

A number of high-profile contract killings are also linked to the work of conversion centres, such as the savage slaying in 2006 of top cop Roman Erokhin, who was tasked with cracking down on conversion centres by former prime minister Yulia Tymoshenko.

But such killings may be only the tip of the iceberg of routine violence and intimidation – as is indicated by Anatoly Rupeta's case.

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In addition, many remember Zeman's time in the PM's office as leader of the Social Democrats (CSSD) in 19982002, which was blighted by corruption scandals, in addition to the cynical "opposition agreement" that saw Klaus' Civic Democrats (ODS) support his government, despite sitting on the other side of the house, in return for influence on policy. The Czech press is rife with analysis that Klaus intends to extend his influence after his term-limited ten years in office through a Zeman presidency.

The prince and the boozer bne

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ilos Zeman, a former leftist prime minister with a good line in witty putdowns, defeated his aristocratic challenger Foreign Minister Karel Schwarzenberg in the second round of the Czech presidential election January 26, becoming the country's first popularly elected president.

The polls had suggested a tight finish to what became a surprisingly bitter race, though in the end Zeman's support in rural areas and the industrial centres in the north and east of the country gave him a comfortable victory of 55% of the vote compared with 45% for Schwarzenberg.

Both men are elder statesman of Czech politics - Zeman is 68, Schwarzenberg even more so at 75. Yet it was Schwarzenberg, rebranded as a mohawk-sporting punk rocker in his campaign posters, who struck a chord with middle-class, young urbanites yearning for a change in the country's venal and corrupt politics, which helped push the turnouts in both rounds to above 60%. That sentiment was credited for Schwarzenberg's late and surprising

surge in the first round, when he took 23.5% of the vote. Zeman won the first round as expected with 24.7%.

Schwarzenberg's campaign had the definite whiff of one whose success was at least partly based on the fact that he was not his opponent, with those voters backing him clearly seeing Zeman as the second coming of President Vaclav Klaus – an arrogant and polarising figure who has dominated Czech political life

Past, present, future That was one of Schwarzenberg’s main lines of attack, having characterised his opponent as a "heavyweight of Czech politics," whose "political views come from the past." Zeman shot back that Schwarzenberg was a politician of the present, tying him to the deeply unpopular austerity policies of the current coalition government, which includes Schwarzenberg's Top09 party.

Schwarzenberg was also branded a foreigner and out-of-touch aristocrat – he spent more than half of his life in exile in Austria, having fled there with other members of his clan, the largest private landowners in the country, when the Nazis invaded in 1940.

Zeman also retains influence with certain factions within the largest opposition party CSSD, despite having left the party in acrimony in 2007.

This is giving rise to fears that Zeman could emulate Klaus in continually

"The left-leaning Zeman will clearly have much to say about the economic policies of the current austerity-wielding administration" for many years. A controversial New Year amnesty announced by Klaus that will release as many as a third of Czech prison population and ending a series of long-running corruption cases is bringing his time in the castle to a controversial and ignominious end.

meddling in the government's affairs.

Klaus famously was in involved in orchestrating the collapse of an ODS government during the country's time when it held the EU rotating presidency in 2009, a humiliation for the country.

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Horses for courses The investigation into a food scare in the UK and Ireland where horsemeat was found in frozen supermarket burgers is zeroing in on Polish suppliers, whose products were labeled as beef.

The food standards agencies said inquiries have concentrated on meat product supplies sent to the Dalepak Hambleton plant in North Yorkshire, England and Silvercrest in County Monaghan, Ireland, one of Europe's biggest burger plants and responsible for making 200m burgers a year, including Tesco's.

Products made for Tesco, Lidl, Aldi and Iceland were found to have horse DNA in the initial scare, although it was the 29% equine DNA in one sample from a Tesco burger made at Silvercrest that sparked further investigations by Irish and UK authorities. Some have caustically argued that with frozen supermarket burgers, customers should be glad they got any meat at all.

"Now we can be very credible as to where this problem came from," Agriculture Minister Simon Coveney told media. "My understanding is that the company involved takes beef product from about five different slaughtering facilities in Poland."

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The post of president is considered largely ceremonial, though does formally appoint prime ministers and, perhaps more importantly, members of the board at the Czech National Bank.

While the country’s first president following the collapse of communism, the late Vaclav Havel, steered well clear of the day-to-day business of government in an apparent attempt to provide emotional and moral leadership, his successor Klaus – a former PM and mainstay of Czech politics since 1990 – has regularly wielded his veto and other points of influence.

Zeman has made it clear he would look to push that further. During the campaign, he said he would attend government meetings regularly, particularly during debates over "vital legislation," and that he would try to convince the government and possibly also parliament of his viewpoint. The left-leaning Zeman will clearly have much to say about the economic policies of the current austerity-wielding administration. However, any new

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parliamentary election would almost certainly put the CSSD back in power,

entitled circle to reclaim the estate.

Why Karel, who did his utmost to get the property from his side of the family restituted, did not meet the deadline to restitute the property from the other side of the family and has since tried to block Elizabeth from attempting to do so, remains a matter of some conjecture.

Zeman's win will mark one significant change from Klaus' ten years in office: Prague Castle will lose its reputation as the most trenchant critic of the EU. The departing president has made it his business to encourage and lead the traditional scepticism of Czechs towards any grandiose scheme, and has compared the EU to the USSR on more than one occasion. That has helped push the country to become one of the very most awkward members of the 27-member bloc.

Zeman, on the other hand, is an avowed europhile. During the campaign, he expressed support for joining the euro and the planned EU banking union – an policy that the government and central bank, rightly proud of the stability of the Czech banking sector, loathe. Those views put Zeman at odds with much of the country; the next five years in Czech politics promise to be no less volatile than the previous five.

The product with the equine material from an EU-accredited Polish supplier was labeled as beef, made from low-value beef cut and trimming product.

"Many remember Zeman's time as PM, which was blighted by corruption scandals and a cynical opposition agreement"

I 33

www.volimkarla.cz

Problem lands in Karel's lap whose vast property holdings that included the chateaux of Hluboka and Cesky Krumlov were confiscated first by the Nazis in 1940 and then the Communists in 1948.

For his part, Karel, whose representatives did not return calls to comment on the verdict, was quoted by the local press as saying in May that he refused to sue the state when asked to by Pezold in 1989, considering such a move "an utterly counterproductive thing to do".

Pezold accuses Karel, who was from a lesser line of the Schwarzenberg clan and adopted by her father Heinrich because he had no male heir, of failing

Counterproductive certainly to his political ambitions, retort his critics, which have just culminated in a losing bid to become the Czech president.

Nicholas Watson in Prague

J

ust as the Czech Republic managed to close one big outstanding property restitution case with the churches on November 23, the other large remaining restitution case burst into life, which promises to be a headache for the just defeated presidential candidate.

In what was a shock verdict even for the family of Elisabeth Pezold, the Czech Constitutional Court on November 22 upheld her claim challenging her adoptive brother's, presidential candidate and current Foreign Minister Karel Schwarzenberg, right to be the heir of the Hluboka (and much grander) branch of the Schwarzenberg family.

"As noted by the Constitutional Court, the Supreme Court previously ignored Mrs Pezold's arguments regarding her position as heiress to Adolph Schwarzenberg," her representatives said in a statement following the verdict. "[T]he Constitutional Court has confirmed what she has been saying all along: that, until now, she has not been granted a fair process."

Elisabeth Pezold is the granddaughter of the late Prince Adolph Schwarzenberg,

His own stated position is somewhat confused in that the reasons he gives seem to keep changing. According to the Pezolds, Karel told Elisabeth that he did not want to apply for restitution during his service for the late president Vaclav Havel until June 30, 1992, but that he would do so afterwards. To date, he has not done so – at first he told her this was due to "conscientious objections"; later he argued that he could not do so because his adoption by her father was not valid under Czech law and so he was not an entitled person under the restitution laws.

"After 10 years, I was slightly surprised at the verdict – we've become accustomed to the fact that justice is not to be granted to us" to meet the wishes of their father stipulated in his will: that his successor should make every effort to get the property back as soon as possible – something he has singularly failed to try to do. As such, he has forfeited his right to be the heir, claims Pezold, because Heinrich Schwarzenberg specifically chose his daughter Elisabeth as the subsidiary heir to the Czech estates in the case that Karel was not part of the

Public opinion Restitution remains a controversial subject in the Czech Republic. The government, after a bruising battle in both the political and public arenas, has just managed to pass into law a church restitution bill, which will give back property and provide compensation worth a total of CZK134bn (about €5.4bn) to the country's churches, over half of that to the Roman Catholic

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Church. The amount is made up of CZK75bn worth of buildings, land and forests that can be proven to have been owned in February 1948 before the Communist coup, and CZK59bn in

The restitution of Prince Adolph Schwarzenberg's property, in which Karel seems so little interested, is made up of some of the finest properties in the land – according to the Pezold website, when the Gestapo took over his properties Adolph Schwarzenberg owned about 55 000 hectares of

the Prague quarter of Hradcany. To have all of this handed back now to a former landowner would not go down well with a Czech public living under harsh austerity measures during a recession.

So where does Pezold's unexpected victory in the Constitutional Court leave the case? Back at square one, according to Adam Pezold, Elisabeth's son, which in this case is the district court

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"The verdict confirms our impression all along, that we have not received a fair trial over all these years, as our evidence has not been examined," says Adam. "After 10 years, I was slightly surprised at the verdict – we've become accustomed to the fact that justice is not to be granted to us."

It's unclear whether the Pezolds voted for their relation Karel in the presidential election on January 26-27; but now he has lost, the billion-crown question is what effect this will have on his attitude toward this restitution issue.

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Central Europe

www.bne.eu

I 35

plier from concluding new long-term contracts with Lithuanian gas importers, which would block the supply of LNG to Lithuania," Joachim Hockertz, deputy general manager of Lietuvos Dujos, says. "There is no need to impose any competition-distorting measures like the mandatory purchase obligation. Such measures would only cause gas prices to go up."

in Ceske Budejovice, south Bohemia.

"The whole process begins again, with one important difference: my mother is now to be treated as heiress unless a court can prove otherwise," Adam says, referring to the Constitutional judgerapporteur Ivana Janu's judgment that the court should either make Pezold another participant in the proceedings or clearly explain why she should not participate in it.

forests, farm land and ponds, various business enterprises, archives and art collections, the castles at Hluboka and Cesky Krumlov, as well as the Zlata Koruna monastery and two palaces in

"The whole process begins again, with one important difference: my mother is now to be treated as heiress unless a court can prove otherwise" financial compensation over the next 30 years for property that can't be returned.

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Terminal illnesses in the Baltics Nicholas Watson in Prague

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he developers of a planned liquefied natural gas (LNG) terminal in Lithuania have won over an initially sceptical new government, but the problems of this project – designed to reduce the Baltic states' reliance on Russian gas – are far from over.

On December 7, the former Lithuanian gas monopoly Lietuvos Dujos announced that it had submitted a complaint the previous day to the European Commission over a law related to the planned LNG terminal being built by the 71% state-owned Klaipedos Nafta on the southern part of the Klaipeda Seaport.

The move came as little surprise. Ever since the Lithuanian parliament passed the law that sets out the legal and financial basis for the LNG terminal back in June 2012, the region's gas consumers have been up in arms over several of the law's provisions.

At the top of the list of gripes is the stipulation that large gas consumers like Lietuvos Dujos must purchase a minimum of 25% of their supplies from the terminal once it goes into operation in 2014, while the costs of construction

and operation of the terminal, its infrastructure and connection to the gas transmission system can be included in the gas tariff.

And that's not all: Lietuvos Dujos says in its complaint to the Commission that the "Law on the LNG Terminal" restricts the application of take-or-pay commitments with regards to contracts for Lithuanian pipeline gas imports but not for imports coming through the terminal, as well as restricting the use of the terminal by enti-

Indeed, the National Control Commission for Prices and Energy, the regulator that controls gas and electricity tariffs, said Lithuania's gas transmission tariffs would nearly double in 2013 as a result of the plan. Lietuvos Dujos puts the potential hike even higher; according to Hockertz, if the full costs of the LNG project are passed on to gas consumers, gas transmission tariffs could treble from current levels. "Klaipeda Nafta's business plan foresees that a major part of the LNG terminal costs will be socialised, by burdening all transmission system users," Hockertz says.

With so much at stake, Lietuvos Dujos is far from alone in its fight against the law. Lithuania's biggest consumers of gas, led by fertilizer producer Achema and the Lithuanian District Heating Association (LDHA), a body representing 31 heating and power producers across the Baltic nation, say they too have petitioned the Commission.

In an August 2012 letter to Brussels addressed to European Commissioner

"If there is no LNG terminal, we have only one monopoly supplier of gas in Lithuania" ties of other EU member states. Those, Lietuvos Dujos claimed in an accompanying statement, are "among the LNG Law's provisions violating EU law."

"Until today state officials and the company appointed to implement the LNG terminal project repeatedly justified the competition-distorting provisions of the law saying that these provisions prevent the current single external sup-

for Energy Gunther Oettinger and Commissioner for Competition Joaquin Almunia, president of the LDHA Vytautas Stasiunas wrote: "The association expresses concern... on the distortion of competition, the equality of market participants, and the freedom to choose a supplier that this LNG Law raises."

Lithuanian fertilizer group Achema, whose gas purchases account for

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around half of total gas consumption in the country, has also petitioned the Commission over the law, warning that its earnings could collapse after 2016 if it is required to pay for a large share of the LNG's construction and operating costs through higher gas transmission tariffs. "This law is a very big problem. In the worse-case scenario, I estimated the additional costs could be over LTL100 million [€29 million]," Valdemaras Vareika, general director of Achema, told local news in September.

"If they [the European Commission] do not do something about this, then we will consider action ourselves."

Never the twain shall meet At the heart of the controversy is the perennial contradiction between energy security and energy economics.

The previous government under former prime minister Andrius Kubilius that instigated the Klaipeda LNG project defended the provisions in the LNG law, saying they make the project commercially stronger and thus help wean Lithuania and its neighbours off Russian gas. Russia is currently the sole gas supplier to the Baltic markets, which are cut off by their Soviet past from European energy networks.

"The reason for this mandatory purchase is to ensure the energy security of Lithuania. If there is no LNG terminal, we have only one monopoly supplier of gas in Lithuania," he told bne on the sidelines of a conference in Riga on September 14.

The new government that took power in December has come out clearly against the previous administrations' plan to build a new nuclear plant at Visaginas, but Prime Minister Algirdas Butkevicius' Social Democrat Party-led coalition has put aside its ambivalent statements during the election campaign about the LNG terminal and stated that it needs to be completed as planned.

"The construction of the LNG terminal in Klaipeda is one of the government's future priority tasks, and it is necessary to ensure the fastest possible implementation of this project," Energy

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Minister Jaroslav Neverovic told the Lithuanian weekly magazine Veidas in an interview published in January.

The PM visited the site of the terminal at the end of December and also stated that the LNG terminal is "one of the most important projects to Lithuania."

However, he added that the process of building the terminal must be closely monitored and deadlines adhered to, a tacit admission that the costs of the terminal are considered high for a country whose economy is experiencing a fragile recovery from the mauling it received during the 2008 global crisis.

Furthermore, in December 2012 the new ruling coalition asked Lithuania's Constitutional Court to examine the constitutionality of the LNG legislation.

The central part of the LNG terminal infrastructure will be a floating storage regasification unit (FSRU). Under a contract worth $689 million, Klaipedos will rent this FSRU being built by Norwegian company Hoegh LNG at the South Korean shipyard of Hyundai Heavy Industries, which has a firststage capacity of 2 billion cm/y and 3 billion cm/y in the second stage, for ten years. After that ten-year period has elapsed, Klaipedos has the right to purchase it and related installations, and to operate them independently.

According to Joanna Hyndle-Hussein of the Warsaw-based Centre for Eastern Studies, the government's decision to make this investment entails a financial risk for Lithuania for two big reasons.

First, the country is not applying for funds from the EU, since Brussels stipulated that for the terminal to qualify for EU aid it would need to be a joint project with its Baltic neighbours – something Lithuania ruled out, much to the annoyance of Estonia and particularly Latvia.

Second, for the economics to work out, it is vital that Lithuania finalises the unbundling procedure by the end of 2014 laid out in the EU's "Third Energy Package" with regard to gas monopoly Lietuvos Dujos (controlled by E.ON Ruhrgas and Gazprom), which owns the gas pipelines in the country, so that gas from the LNG terminal will enter the network without any problems.

Lithuania, perhaps more than most, has been making progress with the unbundling, kicking off an almighty fight with Gazprom in 2012 with its stated intention to fully implement the EU's "Third Energy Package" and split up Lietuvos Dujos, which it has also sued in a Stockholm Arbitration Court, seeking €1.45bn in compensation for over-priced gas supplies since 2004. With similar suits flying from other EU member states and the Commission's own anti-trust investigation launched in September 2012, Gazprom appears to be buckling under the pressure, with Russian media reporting in September 2012 that the Russian state-controlled gas company is preparing to agree to split its European assets into two entities – one selling natural gas to European customers and the other transporting the gas – to avoid anti-trust claims by the European Commission. With analysts saying that may not be enough to satisfy European regulators, the fight is set to continue throughout 2013.

Storing up problems There are further problems with the Klaipeda LNG terminal, argue industry players, concerning storage of the gas.

According to Klaipeda Nafta's published business plan, the terminal will include storage capacity of 170,000 cm, which analysts say will be insufficient once the second stage of the LNG terminal is completed. As such, a deal must be struck with the Latvians to make use of their Incukalns storage facility.

Given the Latvians are still smarting from their exclusion from the project and are also unhappy with the 25% mandatory purchase law that they think infringes EU law, it's hard to see them being very accommodating.

Many energy analysts say the Lithuanians should be applauded for developing and persevering with a project on their own and not being tempted into the pan-regional kind of thinking that has doomed so many energy projects in the region in the past. However, that go-it-alone strategy inevitably carries its own risks.

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to their heavy reliance on hydroelectric power for generation.

For the meantime, the blueprint is merely the basis for discussion in the European Parliament and a variety of regional EU bodies, but will clearly be used to form policy for the coming years.

Juggling sewers and motorways in the EU Tim Gosling in Prague

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he eastern EU member states are locked in a bitter fight to protect their level of cohesion funding in the 2014-2020 EU budget. While those development funds are popular for their use to build high-profile infrastructure such as shiny new motorways, however much they manage to secure, governments may now be forced to spend a larger chunk than they might like on mending leaky water pipes and upgrading sewerage networks.

The European Commission published "A Blueprint to Safeguard Europe's Water Resources" in late November.

According to Sarah Bogaert of Arcadis, one of the authors, the proposals are aimed at supporting EU member states in meeting the targets included in the EU Water Framework Directive (WFD).

That programme, rolled out in 2000, hoped to achieve "good status" for water across the EU by 2015, a deadline the new report notes is "fast approaching". However, the level of compliance is poor in many countries, Bogaert notes. The blueprint is intended to be a carrot, she says, "to try to support member states deal with the lack of improvement, rather than using regulatory measures."

The stick, she notes, exists under the original WFD and is in the armoury to be used. "Germany has already been taken to court, and the European Commission has threatened more enforcement on the original targets."

That mix of carrot and stick then will look to help states improve water quality and management, not only to boost environmental issues such biodiversity and the quality of drinking and swimming water, but also to deal with very real economic issues.

For instance, afflicted by drought, a sharp fall in output by Hungarian

Dirty work As ever, however, when hard cash enters the equation the going will not be easy. At the base of the blueprint is an idea for the European Commission to persuade European governments – and farmers – to direct more of the funding they receive towards achieving the WFD targets. Given the bitter fight in Brussels over the EU's new long-term budget, that is likely to prove especially unpopular.

Talks over the 2014-2020 budget stalled in late November, with the net contributors to the west of the bloc demanding that the budget should reflect the austerity being implemented at national level. The eastern states – net beneficiaries to a man – are fighting that tooth and nail, with cohesion funding their primary focus. They're joined by France, which is jealous of the other big ticket in the budget – the Common Agricultural Policy (CAP).

The betting is that both those programmes, the CAP and cohesion funds, will have to accept some limits given that the European Commission's original budget proposal for a €100bn rise in budget spending failed to be

"The European Commission has identified water as one of its priorities for regional funds in the next budget" agriculture has done much to antagonize the economic slowdown.

A little further south in the Balkans, meanwhile, water shortage is costing governments there millions of euros as they are forced to import electricity due

approved at the Brussels summit in November. "Lots of regions are suffering from the effects of drought on their agriculture," says Bogaert from the international infrastructure and environmental consultancy. "There's a

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lack of funds at farmer level to invest in water efficiency and retention.

The European Commission wants to introduce priority for water in CAP funding."

However, as she adds with no little understatement: "The timing is unfortunate."

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Considering the brutal complaints from CEE over suggestions that they may need to accept a cut in cohesion funding, Brussels is unlikely to find it easy either to influence governments to spend what development funds they do receive to do – quite literally – the dirty work of fixing their pipes and sewers. A shiny new motorway or airport is clearly a far better headline for incumbent administrations. "The European Commission can't provide extra funds," Bogaert notes, "but it has identified water as one of its priorities for regional funds in the next budget – particularly for leakage improvement and waste water treatment."

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"Water leakage and distribution issues are one of the biggest challenges," she continues, "and generally constitute up to 30% of total water loss. However, in the likes of Romania, the Czech Republic, or Bulgaria, there are probably more problems in that area than elsewhere in the EU."

doubts the politicians are capable of carrying out. "For more than 10 years now, LOT has been taken care of by subsequent governments and it still has not managed to get out of trouble.

There are no premises to think that this time it's going to be different," Salek warns.

The issues, she says, are mostly down to the state of water infrastructure.

"Action can be taken to improve matters," Bogaert states bluntly. "It's just a question of spending priorities."

With the airline having been loss-making since 2008, Salek suggests it is now too late to save LOT, as the company has only been sinking deeper into financial trouble and the assets on offer are no longer exciting. "The logo and the slots aren't very good assets. While the logo may have a sentimental value to older generations, younger passengers want good service, good prices and good connections," he insists. "The slots could be a problem as well, because shifting them to Eurolot will also shift all the expenditure that Eurolot would need to find to make use of the slots."

At the same time, she notes that "extending sewerage networks out to some of the more rural areas needs to be completed within the 20142020 budget terms," while CEE states also urgently need to improve their compliance rates on pollution and environmental standards.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

Poland mulls new scheme to give LOT its wings Wojciech Kosc in Warsaw

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n a new twist in the protracted story of the Polish government's attempts to save troubled flag carrier LOT Polish Airlines, the cabinet is reportedly set to discuss a new rescue plan, under which all the airline's assets will be transferred to subsidiary Eurolot.

However, it's questionable that will buy LOT the time it needs to find a saviour.

The assets that are reportedly going to be transferred from LOT to Eurolot are the rights to the LOT brand and logo and its slots – take off and touch down times – that the airline holds at major international airports such as Paris, London and Frankfurt, reports Rzeczpospolita. Moving the assets to Eurolot – formerly a wholly owned subsidiary that is now 62% owned by the state after being spun out of LOT in 2011 – would save the brand name while shedding the company's debt burden, the newspaper writes.

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Central Europe

"The blueprint is intended to be a carrot to support member states in dealing with the lack of improvement, rather than using regulatory measures"

LOT reported a loss of PLN145m (€34m) in 2011, following a loss of PLN163m in 2010. Full data for 2012 has yet to be released, but the airline asked the government for yet another bailout in December. As part of an initial rescue plan that the government made public

earlier in January, Eurolot was set to take over the domestic and European flights, with LOT retaining flights to the US and Asia. However, under the latest scheme, Eurolot would take over all assets and activities. Meanwhile, a government agency is reportedly in the process of negotiating the purchase of the remaining 38% of Eurolot that is currently owned by LOT. "The possibility of Eurolot taking over all of LOT's assets in one step is one of the options considered – some at the treasury ministry (which holds and manages

Brussels troubles Quite apart from the fiscal challenge of supporting the airline, the government is wary of EU regulators and their interpretation governing bailouts. A demand from Brussels to Hungarian flag carrier Malev in early 2012 that it pay back €130m granted in various forms of state aid in 2007-2010 precipitated a collapse in that airline.

In a bid to circumvent that risk, Warsaw has been masking its handouts to LOT as loans rather than public help. Early in January, the government transferred

"The logo and the slots aren't very good assets" Polish state assets) – are pushing very strongly for it," an unnamed source was quoted by Dow Jones as saying. "Details are being fine-tuned now."

PLN400m to the airline, with Prime Minister Donald Tusk insisting it was "a loan that the company will have to pay back."

However, Zbigniew Salek, an aviation analyst and board member of the International Association of Airport Executives (IAAE), warns that if the government goes for the latest scheme, it would require perfect execution to make it work; that's something he

Salek says: "Logic dictates that if there's a plan, it's to avoid getting in trouble with the EU over public help to companies," but he says that without details, it's tricky to tell how the latest restructuring plan on the table will achieve that.

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Fired over Hollywood dreams

bne The Warsaw Stock Exchange fired CEO Ludwik Sobolewski – suspended in December for leveraging his day job to help him pursue his dreams of a career as a major movie producer, or at least help him in his romantic life – at an emergency general meeting on January 17 for breach of business ethics, appointing his former deputy and acting CEO Adam Maciejewski in his stead.

Sobolewski, who ran the state-controlled WSE since 2006, was clearly on a hiding to nothing ever since Mikolaj Budzanowski – minister at the treasury, which holds and manages state owned shares – said in early January that suspending the executive was the "correct and the only possible decision to take," and asked the state Anti-Corruption Office to investigate.

Sobolewski was suspended on December 21 following reports that he had aide Emil Stepien send out emails to companies listed on the WSE's NewConnect alternative market appealing for help in financing "Pharoah's Curse" – a Polish film starring Sobolewski's girlfriend Anna Szarek.

According to Polskie Radio, local media speculated that the recipients of the emails were alarmed that if they refused to become "angels", then their company's relationship with the Warsaw bourse might suffer.

According to media reports, Sobolewski denied any wrongdoing and was officially thanked for his services to the WSE. The exchange did not give reasons for the dismissal nor did the treasury ministry. Maciejewski will do the job until next year when the current management team's mandate ends.

www.kapif.pl

Central Europe I 41 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

bne February 2013

Other officials have been careful to make the right noises, with talks ongoing with Brussels over the loans/bailout and their effect on competition. "If the state is to help, then that help must make sense," Deputy Treasury Minister Pawel Tamborski told the IAR news agency last month. "The restructuring programme is supposed to lead to the airline paying its own way – without that there is no sense in using public funds."

However, that self-reliance looks no closer for LOT, despite several years of shedding assets and attempts to restructure. On top of the funds it has handed out, Warsaw has had to act as a guarantor in other ways. In 2011, for instance, state-owned insurer PZU acquired LOT's Warsaw head office for in excess of PLN100m after the asset failed to attract any other bidders.

What you need to know

Salek suggests that at this point, the latest rescue should be the last, and the company now left to sink or swim.

"What should have been done to save LOT years ago was never done, for example renewal of the fleet or protecting it against the influx of cheaper carriers in late 1990s and early 2000s," he points out.

While Warsaw is clearly hoping that it can come up with a plan that will buy LOT enough time to finally find a buyer after years of trying to offload it, the government has also hinted in recent weeks that it could soon be ready to unplug the flag carrier from life support. "Even if this is going to prove unpopular, I think it's high time to end the doctrine that LOT is a company that must be rescued at all costs, no matter what the reality is," Tusk said on January 3.

With European airlines falling like ninepins in 2012, Warsaw spent much of the year smugly anticipating that it would finally offload LOT, with Turkish Airlines – one of a handful of growing operators from the east looking for a European hub – in detailed talks.

However, that deal broke down in June.

And with little sign of interest from any other suitor since, time is clearly running out.

bne’s veteran team of journalists have more than 100 years of collective experience of reporting on this dynamically growing region and can explain the “why” of “what” is going on.

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"normalization of relations" between the two.

But in a big shift in policy, the document calls for wide autonomy for minority Serbs within Kosovo's borders, which analysts say indirectly recognises Kosovo's sovereignty and territorial integrity. This view was backed by comments from Serbia's nationalist government, a coalition led by the Serbian Progressive Party (nationalists who split from the hardline Radicals and headed by President Tomislav Nikolic) and the Socialists, whose leader is Prime Minister Ivica Dacic, who was the spokesman for Slobodan Milosevic's party during the Kosovan war. Dacic conceded during the parliamentary debate on the resolution that Serbia's sovereignty over the province is all but lost. "Serbian sovereignty over Kosovo is practically non-existent," he was quoted as saying. "We have to create a strong basis to save something… If Serbia keeps its head in the sand, it will have nothing to negotiate about."

Reality bites in Serbia Nicholas Watson in Prague

W

ith even Serbia's nationalist government conceding in January that its erstwhile province of Kosovo is all but lost, the question that has lurked in the background but always promised to be a thornier issue with more immediate consequences is what can be done about the Serb-dominated north of Kosovo.

In a marathon special parliamentary session on January 12 that lasted over 14 hours, the Serbian parliament voted overwhelmingly (175 in favour to 19 opposed) to adopt a binding resolution that forms a "platform" for the country's negotiations over the now-independent ethnic Albanian-dominated state of Kosovo. These talks are being overseen by the EU and resumed on January 15.

Some resolution to the Kosovo issue is a condition laid down by Brussels before

Serbia can make progress in its bid to join the EU. In a convoluted fashion typical for the Balkans, the resolution appears to say one thing while actually meaning another – a way, says Gerard Gallucci, a retired US diplomat and UN peacekeeper who regularly contributes to the Transconflict website,

No but yes, maybe Belgrade's resolution has five basic principles for political negotiations with Pristina, with the first being that Serbia "does not and will never recognise" Kosovo's unilaterally declared independence in 2008 following the Nato bombing that ended the civil war between the Serbs and the ethnic Albanians. This is not surprising,

"If Serbia keeps its head in the sand, it will have nothing to negotiate about" "to accommodate the diametrically opposed views of Kosovo and Serbia on final status while also recognizing the realities on the ground in north Kosovo."

nor is it actually a problem for the EU: Brussels has said recognition of Kosovo's sovereignty is not expected of Serbia; rather, it wants to see a

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While rejecting recognition of Kosovo as an independent state – Kosovo is recognized by over 90 countries including the US and most EU states – the document calls for the creation of an “Autonomous Community” of Kosovo municipalities with non-Albanian majorities modelled on the form of Catalan autonomy within Spain.

The document has inevitably been criticised from all sides. For very different reasons, the Serbian opposition parties the Democratic Party of Serbia (DSS) and Liberal Democratic Party (LDP) voted against the resolution. "While the LDP is calling for Serbia to drop its territorial claims and fully recognise Kosovan independence, the DSS strongly accuses the government of effectively cementing the border between the two sides," IHS Global Insight says. "In reality, the document is a bargaining ploy which strengthens Serbia's hand in negotiations on normalising the bilateral relationship between Kosovo and Serbia, and achieves a safe political platform at home for the dialogue with representatives of Pristina."

Slovenes fail to come clean

bne Following a successful Eurobond issue and a calm presidential election at the end of 2012, things were looking up for Slovenia, raising hopes that it would avoid in 2013 becoming the next Eurozone country to require an international bailout. Instead, the country is now gripped in a political crisis that could bring down the government.

Following the release by the country's anti-corruption commission of a report that looked into top politicians' assets, pressure began mounting in January on Prime Minister Janez Jansa to resign after he failed to adequately explain the origin of some of his income.

The PM denied there was anything suspicious and he was backed by strong support within his centre-right Slovenian Democratic Party, which leads the coalition government. But smaller coalition partners said they were considering quitting the government. "If Jansa does not resign in 10 days ... the Civic List (CL) will no longer be a member of the coalition," the head of the CL, parliamentary speaker Gregor Virant, said on January 12 after a meeting of the party's council. The CL holds seven seats in the 48-seat coalition. The parliament has 90 seats, meaning the government would lose its parliamentary majority if the party quit.

Growing anger from the public was also putting pressure on Jansa, with more than 8,000 people gathering for a mass rally on January 11 in the capital Ljubljana to demand his resignation. The rally was one of the largest staged in Slovenia in recent years and the police had to use tear gas to disperse demonstrators who tried to break barriers and enter the parliament building.

Analysts say a political crisis could be averted with Jansa’s resignation and his party nominating a new person to lead the government. "If Jansa retains his post, public outrage could only intensify, while cracks in the government would deepen, putting the government's mid- to long-term prospects at risk anyway," say analysts at IHS Global Insight.

The crisis comes at a critical time for Slovenia, which is desperately trying to avoid becoming the next Eurozone country to have to ask for a bailout due to recession and vast amounts of bad loans at state banks. Another early election – only just over a year since the last snap poll was held – would put the reforms that the current government is trying to implement to stave off economic collapse in jeopardy.

Not that the opposition is looking much better placed to win any fresh election or take advantage of the situation. Opposition leader Zoran Jankovic, who is also mayor of Ljubljana, said on January 12 that he would not run for prime minister because the anti-corruption commission had said he too was unable to explain the origin of some of his income.

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bne:infrastructure

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The Kosovan government also slammed the resolution for being a backward step; it has always (without a hint of irony) rejected any deal that threatens

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Southeast Europe

2,000-megawatt (MW) Belene plant was made in 2005 with an international tender to choose a reactor maker.

That tender was won by Russia's Atomstroyexport in 2006, which officially began building the plant in September 2008, some 27 years after the site was originally approved in 1981.

Completion of the two reactors was forecast for December 2013 (unit 1) and June 2014 (unit 2).

The resolution brought a bout of sabrerattling from various nasty groups who always seem to emerge at moments like these and give the diplomats in

"The Kosovo Albanian side says any effort to recognize the uniqueness of the north would lead to regional instability "

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

Register and sign up for the list here: www.businessneweurope.eu/ users/register.php

the territorial integrity of Kosovo.

Gallucci says the Kosovo Albanians still want to win everything and reject the merest hint of compromise over the north of Kosovo, so their response – the one used successfully in the past – is to try to scare the international community by raising "the spectre of irredentism", where enclaves administered by another state are annexed on the grounds of common ethnicity or prior historical possession, actual or alleged – in the region. In other words, the "Greater Albania" that Serbs have so often screamed about and used to justify the Kosovo war in the first place. "The Kosovo Albanian side has often hinted that any effort to recognize the uniqueness of the north would lead to regional instability in the form of pressure from Albanians in southern Serbia and Macedonia," says Gallucci.

Brussels conniptions. Gallucci says the so-called Albanian National Army (ANA) in Kosovo threatened armed action, reportedly saying that it would mobilize its members to defend against Serb threats to secede a part of Kosovo territory.

However, few expect violence on any wide scale. Rather, with no Serbian government ready to agree to recognize Kosovo's independence, this leaves nowhere to go to settle the Kosovo issue except by the formula that is now on the table. As Gallucci explains: "Set aside the issue of recognition, keep the north in Kosovo but with increased local autonomy, reach status-neutral approaches to issues such as customs, property, telecoms and electricity. Let both Serbia and Kosovo prepare for the EU."

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Bulgaria's "meaningless" referendum Nicholas Watson in Prague

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ven by the notoriously slow standards of the nuclear industry, the 30-plus years that Bulgaria's nuclear power plant at Belene has been under construction must serve as some kind of a record. And the January 27 national referendum on whether or not to restart building the on-again-offagain nuclear plant is unlikely to provide any clear indication of its fate.

When referendum day came, the results were an anti-climax – or rather would have been had they had not been predicted by just about every pollster in Bulgaria. For a referendum result to be binding, according to Bulgarian law, it's necessary not just that more than 50% of votes cast be "yes" votes, but that the total vote be at least as high as that achieved in the preceding general election: the latter number (in 2009) was 4.2m – a healthy 61% of the total current electorate according to the (probably rather inflated) official figures. The referendum turnout was, well, a tad lower – at 21.8%, according to the latest reports.

That, admittedly, doesn't leave the referendum quite without result: the

rules also say that if the votes cast exceed 20% of those eligible and more than 50% of those are "yes" votes, the question must be referred for debate in parliament. Both conditions were fulfilled: with around 97% of votes counted, the Central Electoral Commission said that 60.55% had said "yes". No big deal, it seems: at the postreferendum press conference, Prime Minister Boiko Borisov told journalists

However, only preliminary site activities were carried out and later suspended because inevitably things immediately started to go awry: delays and other problems saw the plant's price soar above the originally estimated €4bn; the global crisis struck in 2008; the government's strategic investor, German utility RWE, pulled out in 2009; and the Bulgarian Socialist Party was ousted in elections that year by Prime Minister Boyko Borisov's GERB party, which after waffling for several years over the subject finally killed it in March last year.

That decision infuriated the Russians (perhaps understandably), as well as the Bulgarian Socialist Party and its supporters (less understandably so).

The Russians have now decided to sue the Bulgarian state for more than €1bn in an international arbitration court to try to recoup some of the losses they claim they have incurred, while the Bulgarian Socialist Party is pushing to

"The reason why so many are keen to see the Belene project keep rumbling along is money – and lots of it" that when the issue came up for debate it would just be voted down by MPs from his Citizens for European Development of Bulgaria (GERB, in its Bulgarian acronym).

The referendum was pushed by the opposition Bulgarian Socialist Party (BSP), which was in power when the latest move to restart building the

restart a project they say is essential to Bulgaria's economy and its future energy security. The Russians may well have a point, but critics say the arguments put forward by supporters of Belene are economically illiterate.

Boondoggle at work The advisory firm Candole Partners in a 2010 report calculated that Belene

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would have to sell electricity anywhere between its variable cost (€21 per megawatt hour) and its total cost (€5180/MWh), which is three- to ten-times higher than the price that the country's other nuclear plant at Kozloduy sells at on the regulated market. These kind of numbers are backed by HSBC, which was hired by the Borisov government to do an audit of the Belene project and put the cost of the plant at €10.35bn under the best-case scenario, which works out at about €75/MWh. The government has used the HSBC report to justify its decision to scrap the project, though some sources question HSBC's objectivity given the global lender was picked as one of the

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Alarm bells started ringing, though, when it turned out Bogomil Manchev was involved, a man whose tentacles reach deep into Bulgaria's energy and construction business through his Risk Engineering company and who featured in US diplomatic cables leaked

by Wikileaks that bore the heading, "DIRTY ENERGY: CORRUPTION AND LACK OF TRANSPARENCY PLAGUE BULGARIAN ENERGY SECTOR". Manchev declared that the consortium brought together George Soros' investment fund Quantum Group, two large strategic investors, a big US bank and one operator.

Emil Harsev, described by one local as an "innovative-minded Bulgarian financier", also turned out to be acting

"A total of BGN300m allocated in the state budget in 2008 for the creation of a BulgarianGerman joint venture to build the Belene plant disappeared" lead arrangers for the state's €950m Eurobond that was issued just months later. Even so, as Georgi Vukov of Candole Partners in Sofia, points out, if the project was economically sound, there would have been more interest from the private sector. "I don't see it as a profitable project and this is reflected in the lack of private investor interest," says Vukov. "If it was even a breakeven project, someone by now would have expressed an interest after RWE pulled out."

In fact, there has been some private sector interest shown, but the farce surrounding that event only highlighted the project's dismal prospects and the real reason why the Bulgarian Socialist Party and other actors are so keen to keep Belene alive.

In September, a hitherto unknown and recently US-registered company called Global Power Consortium out of the blue expressed an interest in negotiating with the government to become a strategic investor in the project.

as a consultant to the mysterious Global Power Consortium; he told Novinite that a total of nine companies were involved in Global Power Consortium, which apparently had already made contact with Atomstroyexport. Alas, later enquiries found that neither Quantum nor Atomstroyexport had ever heard of Global Power Consortium.

The Global Power Consortium rigmarole illustrates well the real reason why so many are keen to see the Belene project keep rumbling along: money – and lots of it.

On December 5, Novinite revealed that a report from the Public Financial Inspection Agency (PFIA), now before a parliamentary committee, had found that a total of BGN300m (€153m) allocated in the state budget in 2008 for the creation of a Bulgarian-German joint venture to build the Belene plant had disappeared.

According to the PFIA report, the money was spent even though the BulgarianGerman company was never registered.

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Southeast Europe

Before that revelation, independent estimates put the amount of money spent on what is currently a large construction site at Belene at anywhere between €600m and €1bn. Even if nothing more is built or upgraded at Belene, the site needs to be maintained, which costs tens of millions a year.

And should the project go ahead, local subcontractors like the ten that the Wikileaks cables claim belong to Manchev would benefit enormously.

And as Candole's Vukov notes, "as is often the case in Bulgaria, these subcontractors are never chosen by the most transparent procedures."

So if the money explains much of why the elites are so keen to see Belene at the very least remain on oxygen, how does the referendum fit into their plans?

Vote yes or no, it doesn't matter Both sides are making the best of it. BSP leader Sergei Stanishev and friends are arguing that the referendum results amounted to a vote of no-confidence in Borisov, dismissing low turnout with the argument that, a few years back, Borisov himself was elected Sofia mayor on the strength of support by no more than 20% of those able to vote. Borisov and his followers, by contrast, see the referendum as a flop that reflects badly on its initiator and have been calculating how many new nurseries or apartment block rehabilitations could have been financed by the €10m-13m money spent on the "pointless" vote.

Sadly for Bulgarian democracy, both have a point. And, as for the subject of the referendum, that's no nearer solution. Borisov can block any moves to revive Belene this side of elections. But a hypothetically resurgent BSP might, marginally fortified by its technical success on this occasion, have better chances of reviving it thereafter – if its instincts for self-deception and selfimmolation are as strong as they have been in the past

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infrastructure projects scuppered by financing problems.

Turkey sold 25-year operating rights for 1,975 km of toll roads, including those on the Bosporus and the Fatih Sultan Mehmet Bridges, which both cross the Bosporus Strait to connect European and Asian Istanbul. The assets, which were sold in Turkey's second-biggest privatisation and trumped only by the $6.55bn sale of 55% in Turk Telekom in 2005, also include the Edirne-Istanbul-Ankara highway and the Ankara ring road.

Build it and they will come to Turkey bne

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urkey's infrastructure is attracting a growing amount of investor interest, with the government successfully selling off bridges and roads in December, and now preparing a tender to build a third airport in Istanbul.

The head of Turkish infrastructure group Limak Yatirim Holding told Reuters that it expects the government to outline terms for the construction of a third airport in Istanbul in the coming weeks and the planned tender is already generating a great deal of interest. "We expect the tender terms to be released this month," Limak Yatirim chairwoman Ebru Ozdemir was quoted as saying on January 14. "There is big interest from international and domestic players in the process, especially foreign firms are knocking at our door for partnering for the tender."

A new airport is becoming increasingly necessary as passenger traffic through Turkey's capital has risen sharply in recent years. Flag carrier Turkish Airlines, one of the world's fastest growing carriers, has expanded routes around the world using the city as its hub, while

smaller airlines like Pegasus Airlines (see box) are expanding to cater for the growth in domestic travel by the rising middle class. The third Istanbul airport is planned to have an initial capacity for 90m passengers a year, extending eventually to 150m passengers, and three runways.

Bridge and tunnel crowd The tender follows the successful sale in December of a pair of Bosporus bridges and around 2,000 kilometres of motorways at the fourth time of asking on December 17, as a consortium comprising local giants Koc Holding and Yildiz Holding, in partnership with

Koc, Turkey's biggest conglomerate, and UEM each hold a 40% stake in the winning consortium, while Gozde – the venture capital unit of Yildiz Holding – holds 20%. The bid is subject to approval by the Privatisation Administration, Competition Board and Council of State.

Ankara was delighted to get the sale away successfully. It adds to growing success in the country's privatisation drive in recent months after a period during which sales of transport and energy infrastructure struggled due to the difficulties that bidders had in raising the necessary finance, as the three previous failed attempts to sell off the motorway package attested to. However, evidence that Turkey has managed to engineer a soft landing for its booming economy and greater availability of finance in the international markets have helped the government sell off assets.

At the end of last year Fitch Ratings upgraded the country's credit rating to give it its first investment grade since 1994 , and analysts described "euphoria" in the markets following

"Foreign firms are knocking at our door for partnering for the tender" Malaysia's UEM Group, won a tender for the giant infrastructure package for $5.7bn. That the sale finally went through was a relief for Ankara, which has seen numerous attempts to sell off

the move. A wave of corporate issues is now anticipated, especially given the current volume of cash hunting for yield in emerging markets. Meanwhile, Ankara has been driving hard to open

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Pegasus flies

bne The Istanbul-based budget carrier Pegasus Airlines launched Turkey's largest single aircraft order in December as it looks to buy at least 75 Airbus medium-haul planes. The move illustrates the huge disparity between the stunning rate of growth that the Turkish airline industry is enjoying and the dire state of the sector in the rest Europe.

Pegasus, which has grown its fleet from just two aircraft to more than 40 over the past two decades and now serves 52 destinations in 24 countries, placed a firm order for 58 fuel-saving A320neo aircraft and 17 A321neo jets.

The airline currently uses aircraft built by Boeing, but switched allegiance after what industry sources described as a tough fight between the arch rivals for the contract.

The new aircraft have a combined list price of $7.5bn. The deal also includes options for a further 25 aircraft. If all options are exercised, the deal's value for 100 planes could peak at $9.9bn, based on official Airbus prices, reports Reuters. According to other sources, the list price of the full deal could add up to over $12bn.

"When our first Pegasus flight took off we broke new ground by placing the biggest order in the history of Turkish private civil aviation at the time," Pegasus chairman Ali Sabanci said at a signing ceremony, which was also attended by Transport Minister Binali Yildirim. "As we look ahead to the next decade, we know that, apart from human resources, an airline's most important asset is its fleet. Therefore, once again, we have said to ourselves, 'we don't yet have enough.'"

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Southeast Europe

Alongside a little more flexibility from the authorities, those improved conditions have seen a series of stalled projects and privatisations start to trickle through. While the secondary public offering of a 24% stake in statecontrolled Halkbank for $2.5bn would likely have proved popular regardless of any improvements in the economic climate, infrastructure assets in particular have struggled in Turkey.

After several failed attempts to whip up interest, the North Marmara Highway Project – which includes construction of a third bridge to span the Bosphorus – was finally sold in May after it was reduced in scale and scope.

The contractors on the project agreed financing with six Turkish banks in November.

Meanwhile, Bogazici EDAS – the largest power distributor in the country, which runs the Istanbul grid – was also sold in December for $1.96bn. The asset was one of eight regional distributors for which a sale in 2010 fell through.

"A new airport is becoming increasingly necessary as passenger traffic through Turkey's capital has risen sharply in recent years"

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However, CEZ counters that it has been forced to run the company at a loss due to a hike in wholesale prices from the state-owned generator, while not being allowed to raise consumer tariffs. Furthermore, many households and businesses, both state and private sector, simply don’t pay their electricity bills. In November, CEZ cut off several of the country's water companies for non-payment, but the authorities went to the politically pliable courts, which forced the company to hook them back up.

the way for Islamic finance to offer an alternative to the country's heavy reliance on Europe's creaking banks.

The company's current aggressive expansion highlights the rapid growth in Turkish aviation, and follows recent orders from flag carrier Turkish Airlines for long-range aircraft from both Boeing and Airbus. Turkish carriers are adding routes around the region and raising capacity on domestic flights in a bid to serve booming demand. The number of passengers carried in the Turkish air grew by 10% year on year to 121.8m in the first 11 months of 2012.

That growth has seen Turkish Airlines included in a select band of potential saviours that Europe's struggling flag carriers are courting for investment. Alongside operators from the Middle and Far East, the company is hunting for a European hub to form part of its global network. It pulled out of advanced talks to buy Polish LOT Airlines earlier this year due to EU regulations designed to prevent controlling stakes in airlines heading outside the bloc.

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Albania pulls the plug on CEZ bne

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CEZ criticized the regulator's decision and said that it would seek international arbitration while it looks to sell the subsidiary, which is dragging on the group's earnings.

"Such a move is in violation of local laws and CEZ will file a formal protest.

At the same time, the company will take initial steps toward international arbitration," the company said in a statement.

Tirana is blocking any sale by CEZ until it coughs up compensation for the alleged breaches. Following the revocation of the licence, ERE leveraged Albanian energy legislation to put CEZ Shperndarje in temporary administration and appoint a new manager to oversee the business while the dispute persists.

o the surprise of few, following a long and bitter fight Albania's power regulator ERE on January 21 followed through on its threat to revoke the distribution licence of the local unit of Czech utility CEZ.

company was seen as a strong player to help improve the sclerotic Albanian power sector. Analysts say the issue will almost certainly harm Albania's

The regulatory board voted 5-0 to revoke the licence of CEZ's loss-making local subsidiary CEZ Shperndarje, arguing that the Czech company had breached the terms of its license. It had failed to invest in order to limit electricity losses in the distribution system and failed to import the required amount of power needed to meet the percentage of Albania's power deficit agreed in the licence, the regulator claimed.

"Such a move is in violation of local laws and CEZ will file a formal protest"

The move is the latest twist in a long-running saga that has seen CEZ at loggerheads with Tirana since it bought the distribution company for €102m in 2009. The deal gained World Bank backing, as the Czech

reputation as a foreign investment destination.

ERE did not specify the amount it would seek in damages from the Czech company, but the Albanian government has estimated the cost at $1bn. "The main thing is they could not control the power losses … that means they could not control debt and they could not control problems in the industry," ERE chairman Sokol Ramadani told Reuters after the hearing.

"We see the news neutral [for CEZ], as it was more or less expected," says Petr Bartek of Ceska Sporitlena, who notes that there is a €60m guarantee provided to CEZ from the World bank, which should cover most of the losses, depending on the result of any arbitration.

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dropped by at least 30% since 2008.

In April, fashion retailer Xnation shut up shop with the loss of roughly 250 jobs after a planned recapitalisation by the firm's German-Slovenian business partner failed to materialise. Ironically, Xnation owner Mile Kozul had tried to fight off competition from international fashion retailers by moving production of its high fashion clothing range to China from factories in Croatia and Bosnia-Herzegovina.

Photos © Pounje

Croatia's clothing industry looks to smarten up its act Guy Norton in Zagreb

L

ike many of its peers in the country's manufacturing sector, Croatia's clothing and textile industry has found the transition from a socialist self-management to a freemarket economy model to be a highly challenging one.

Before Croatia declared independence from Yugoslavia in 1991, it employed over 83,000 workers and was an important source of hard currency for the country. However, given a toxic combination of war damage, the breakdown in trade relations between the former Yugoslav republics, and the onslaught of competition from both high-end Western European clothing retailers and low-cost textile manufacturers from Asia, the industry's financial fortunes have been decimated over the last two decades.

With Croatia mired in recession since 2008, the recent past has been particularly hard, with a number of once famous names failing to keep pace with the fierce competition for customers at both home and abroad. Although

at a legal minimum level of HRK2,700 (€360) a month, wages in the textile and clothing industry are among the lowest of all the industrial sectors in Croatia, they are nevertheless at least four-times higher than those that workers in countries such as Bangladesh or Cambodia can command working for multinational

Then in May, womenswear firm Angel based in Medimurje in northern Croatia, whose owner Ruza Djurkin had steadfastly refused to abandon manufacturing clothing in Croatia, closed its doors with the loss of 50 jobs. In the same month, the Croatian government was forced to step in to rescue the knitwear company Pounje Trikotaza based in the central Croatian town of Hrvatska Kostajnica and save 95 employees from the dole queue, converting HRK5.8m of debts to the state into a government shareholding in the company, giving it some muchneeded breathing space to turn its fortunes around. The move gave some temporary relief to the firm's shareholders who had seen their stock fall from a high of HRK5 in January 2007 to a low of HRK0.5 before the government stepped in to rescue the firm in May. Hopes that Pounje can attract a strategic investment from

"Although at a legal minimum level, wages in Croatia are at least four-times higher than those in countries such as Bangladesh or Cambodia" companies such as Sweden's Hennes & Mauritz, which has launched a concerted assault on the Croatian market in the last 12 months.

2013 proved to be a particularly cruel one for the embattled fashion industry in Croatia, with a number of oncemajor names having gone to the wall in the face of fast-shrinking spending by consumers in Croatia, which has

Slovenian Modiano have since seen the shares trade up recently to HRK1.13.

Meanwhile, the country's largest clothing company Varteks which currently employs 2,300 workers in the northwestern Croatian city of Varazdin, announced in late July it was shedding around 100 jobs as part of a restructuring plan to help ensure its continued survival. The company's financial

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troubles means that it owes the central government roughly HRK130m in unpaid taxes.

Dressing up for the EU Despite its recent trials and tribulations however, the textile and clothing industry is still the second largest employer in the manufacturing sector in Croatia, with around 20,000 employees, and is the country's third largest exporter accounting for 8.2% of Croatia's industrial exports. With the prospect of Croatia joining the EU on July 1, 2013, there is also hope that firms will be able to attract fresh capital from both home and abroad, while foreign manufacturers – especially those from higher cost EU members – may be tempted to set up new factories in Croatia.

Although much higher than those in Southeast Asia, labour costs in Croatia are reckoned to be on average at least 50% lower than those in traditional European fashion industry hotspots such as Italy, according to the Croatian Chamber of Commerce. Furthermore, with the Croatian government keen to promote greenfield developments in employment blackspots, international firms can receive subsidies of 20% of the start-up cost for new operations in Croatian regions where the unemployment rate is at least 20%.

Croatia has, therefore, succeeded in attracting the likes of Italian clothing brands Benetton and Calzedonia to establish factories in the country, while Austria's Boxmark, which manufactures leather upholstery for the likes of Audi, Bugatti, Opel and Porsche has proved to be a major manufacturing force in Croatia since it established a factory in Varazdin in 2001, with overseas sales worth around €135m a year, making it one of Croatia's leading exporters.

There's still considerable uncertainty facing a number of once major companies in the sector, however. Slavonija Modna Konfekcija (SMK), for example, finds itself embroiled in a life-or-death struggle for existence if it fails to turn its financial performance around in the near future. Based in Osijek, the capital of the Slavonia region in eastern Croatia,

Southeast Europe

SMK's bank accounts have been blocked for the last seven years because of outstanding debts and it has only been able to survive thanks to the largesse of Audio, Croatia's Agency for State Property Management, which manages the government's roughly 80% shareholding in the firm. Last year alone, the company racked up of losses of HRK17.3m and the company has been struggling to pay wages and social security contributions for its 260 employees. It recently

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has a future… it will require a lot of work and effort, but I am confident that we can achieve better results."

As well as seeking new customers abroad one of the key priorities of the new management is to up the proportion of revenues it derives from Croatia – currently it stands at a measly 10% - on the basis that once the blockade on its bank account is lifted it will be able to compete for business from the Croatian

"Croatia has succeeded in attracting the likes of Italian clothing brands Benetton and Calzedonia to establish factories" ranked in 18th place among the leading tax debtors to the Croatian government, with outstanding dues of HRK47.2m.

Given its recent troubles, it's no surprise that the value of its thinly traded shares which are listed on the Zagreb Stock Exchange have slumped from almost HRK90 in August 2007 to just HRK2 five years later.

Founded in 1945, SMK was once a flagship firm in Slavonia, employing over 4,000 workers and selling men's and women's clothing throughout Yugoslavia. With the break-up of Yugoslavia in the 1990s, it suffered both extensive war damage as well as losing traditional customers in the former Yugoslavia and like many of its peers it is struggling to compete for customers given the increasing volumes of cheap imports to Croatia.

Consequently, chief executive officer Miljenko Babic who was brought in to help turn SMK's fortunes around in June, believes that the firm will have to cut its coat according to its cloth and as part of a restructuring programme move to new, much smaller manufacturing premises if it is to have a viable future.

"After getting acquainted with the basic information about the business and the balance sheet of the company, we found that the situation in SMK is not great," admits Babic, adding: "I think Slavonia

army, police and state-owned companies. It also plans to expand its range of clothing from its in-house Tref brand of menswear and womenswear to include children's clothing and protective workwear. Furthermore, the firm is hoping to receive a new strategic partner after the government announced a public tender for SMK offering up its 78.95% stake in the firm for sale. Two, as yet unnamed, bidders have expressed an interest in the stake in October. Whether a new owner will be able to provide the necessary financial wherewithal to help SMK to stave off bankruptcy remains to be seen however.

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president for research. "Our findings point to the growing sophistication of modern authoritarians… They are flexible; they distort and abuse the legal framework; they are adept at the techniques of modern propaganda."

However, improvements were also noted in several CEE countries, including Armenia, Bosnia-Herzegovina and Georgia, as well as in the disputed territories of Abkhazia and NagornoKarabakh, the latter of which moved from "Not Free" to "Partly Free."

Unsurprisingly, Putin is firmly in the Freedom House sights. "Since his inauguration in May," the report insists, "Putin has moved in a calculated way to stifle independent political and civic activity, pushing through a series of laws meant to restrict public protest, limit the work of NGOs, and inhibit free expression on the internet."

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urasia is "the world's least free subregion," the latest report from Freedom House on the state of global freedom claims, pointing the finger at regimes in Russia and Central Asia that have clamped down on opposition in response to the events of the Arab Spring.

While the number of countries ranked as "Free" in 2012 was 90, a gain of three over the previous year, 27 countries showed significant declines, compared with notable gains in just 16, according to "Freedom in the World 2013", the annual report on the state of global freedom from the largely US statefunded Freedom House.

This is the seventh consecutive year that "Freedom in the World" has shown more declines than gains worldwide.

Furthermore, the findings reflect a stepped-up campaign of persecution by dictators that specifically targeted civil society organisations and independent media, the report says.

Among the most striking gains for freedom was Libya, which advanced

from "Not Free" to "Partly Free" and registered one of the most substantial one-year numerical improvements in the report's nearly 40-year history. Burma and a number of African countries, including Cote d'Ivoire, Guinea, Lesotho, Senegal, and Sierra Leone, also saw major advances. However, noteworthy declines were recorded for several countries, including Kazakhstan, Russia, Turkey, Tajikistan and Ukraine.

The problem with Vladimir The return of Vladimir Putin to the Russian presidency ushered in a new period of accelerated repression, Freedom House claims. "With Russia setting the tone, Eurasia (consisting

most repressive areas on the globe.

Indeed, Eurasia is in many respects the world's least free subregion, given the entrenchment of autocrats in most of its 12 countries," the report insists.

In particular, Freedom House suggests that the events of the Arab Spring have rattled the regimes in Eurasia, promoting a clampdown on opposition movements. A "number of regions experienced setbacks due to a hardened and increasingly shrewd authoritarian response to these movements," the report says.

That trend is also reflected across other former Soviet states, according to Freedom House, which laments that "authoritarian temptation poses a threat even in Eurasian countries with recent histories of dynamic, if erratic, democratic governance."

"Thus Ukraine suffered a decline for a second year due to the politically 2012 Freedom in the World

"Especially since the Arab Spring, they are nervous, which accounts for their

"With Russia setting the tone, Eurasia rivals the Middle East as one of the most repressive areas on the globe" of the countries of the former Soviet Union minus the Baltic states) now rivals the Middle East as one of the

intensified persecution of popular movements for change," explains Arch Puddington, Freedom House vice

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Free Partly free Not free

motivated imprisonment of opposition leaders, flawed legislative elections, and a new law favoring the Russianspeaking portion of the population," the report notes. "In Central Asia, Tajikistan’s civil liberties rating declined due to a military operation in GornoBadakhshan, which resulted in scores of deaths, extrajudicial killings, and a media crackdown. Kazakhstan’s media environment deteriorated in the wake of a crackdown on labor unrest in late 2011, with authorities banning opposition newspapers and blocking opposition websites and social media."

However, the effects of the recent unrest in the Middle East and North Africa are not restricted to former Soviet states, Freedom House suggests. Turkey's increasingly acerbic government is putting civil liberties at risk, the report notes. "During his early years in power, Prime Minister Recep Tayyip Erdogan pushed through important reforms that enshrined civilian rule, enhanced fairness at the polls, and made halting steps toward greater minority rights," the report reads. "More recently, however, his government has jailed hundreds of journalists, academics, opposition party officials, and military officers in a series of prosecutions aimed at alleged conspiracies against the state and Kurdish organizations.

Turkey currently leads the world in the number of journalists behind bars, and democracy advocates are expressing deep concern for the state of press freedom and the rule of law."

Not for the first time in such reports, what praise there is remains reserved for the closest US allies in the region.

The most notable progress was seen in Georgia, Freedom House decides, with the country earning improvement in its political rights rating after the opposition Georgian Dream party won competitive parliamentary elections late last year. "The vote led to an orderly and democratic transfer of power, the first in the nation’s history, and the campaign featured more pluralistic media coverage," the report claims, before noting that several officials from the new administration's predecessor have been arrested, "prompting claims of a political witch hunt."

"Armenia's political rights rating rose due to peaceful parliamentary elections in May, which rebalanced the decline stemming from the violent aftermath of the 2008 presidential vote," the NGO also points out.

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against alleged vote rigging. Ten people – eight protestors and two law enforcement officers – were killed when the protesters were violently dispersed from a square in central Yerevan.

However, Ter-Petrossian's ANC, which now holds seven seats in the parliament, has entered into a dialogue with the ruling Republican Party. "Ter-Petrossian has felt it was wiser not to stand at this time, but rather to work as a constructive opposition within the existing system.

He has, I believe correctly, judged that his efforts as an agent of change have passed and at this point it would actually be counter-productive to stand," Giragosian tells bne.

Sargsyan's second term Clare Nuttall in Astana

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ith the two main opposition groups opting not to take part in Armenia's February 18 presidential election, the incumbent Serzh Sargsyan is on track to easily secure a second term in office. In contrast to his first term, which got off to a rocky start when his victory was marred by violent protests and allegations of vote rigging, Sargsyan is likely to embark on his second and final term with a strong mandate to carry out anti-corruption and foreign policy reforms, and may also be tempted to improve relations with Armenia's neighbours, Azerbaijan and Turkey.

A total of eight candidates were officially registered at an extraordinary session of the Central Electoral Commission on January 14. Aside from Sargsyan, the two political heavyweights are Heritage Party leader Raffi Hovannisian, and former prime minister and Liberty Party leader Hrant Bagratian. More notable is the absence of the leader of the second largest party in parliament, the Prosperous Armenia Party, and the head of the Armenian National Congress (ANC) opposition coalition.

Gagik Tsarukyan, head of Prosperous Armenia, the main coalition partner

of Sargsyan's Republican Party until the May 2012 parliamentary elections, announced on December 12 that he would neither stand in the elections nor support any other candidate. His announcement came just four days after a private meeting with Sargsyan, giving rise to speculation about a behind-thescenes agreement. However, Richard Giragosian, director of the Yerevanbased Regional Studies Center, points out that the move was not unexpected, since the wealthy businessman was "never fully respected or accepted as a viable presidential contender."

Meanwhile, the current leader of the ANC and the first president of an independent Armenia from 1991 to 1998, Levon Ter-Petrossian, has also declined

Building bridges Because of the post-election violence and the vote-rigging allegations, it took a long time for the newly elected Sargsyan to be seen as fully legitimate, and to step out from the shadow of his predecessor, former president Robert Kocharyan.

After coming to office, however, Sargsyan has diverged from Kocharyan in the foreign policy arena with his attempts to build bridges with Turkey and work towards a peaceful settlement of the Nagorno-Karabakh conflict with Azerbaijan. Sargsyan became the first Armenian president to hold face-to-face negotiations with his Azeri counterpart, meeting several times with Ilham Aliyev, although there have been few concrete results from the talks so far.

Sargsyan also got a strong boost from the May 2012 parliamentary elections, which gave his Republican Party 69 seats in the parliament, allowing the party to dispense with its former coalition partner Prosperous Armenia.

"Given a second mandate, Sargsyan should be able to begin thinking of his legacy" to stand this time. Ter-Petrossian stood again for president in 2008 and was runner-up to Sargsyan in that disputed election, his defeat prompting his supporters to take to the streets in protest

Despite criticism from international observers, the 2012 elections were generally recognised as Armenia's cleanest and most competitive to date.

A relatively fair fight is also expected

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in 2013, especially given that the president has little to fear from any of his opponents.

In his pre-election speeches, Sargsyan has appeared confident about his re-election, and pledged to introduce new reforms to strengthen the rule of law and improve the economy if re-elected. "There is no doubt in my mind that we will win and will see the Armenia of our dreams – strong, prosperous and secure," he told the Republican Party congress on December 15.

Sargsyan also defended his government's handling of the recent economic crisis, which caused the economy to contract by around 15% in 2009. Since then it has returned to modest growth, expanding by 3.9% in 2012, according to the International Monetary Fund. Inspired by what's happened in neighbouring Georgia, grassroots pressure for more progress in tackling corruption has also been growing. However, Armenia remains in 105th place out of 174 countries on Transparency International's 2012 Corruption Perceptions Index.

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Giragosian forecasts that in his second and under the constitution final term as president, Sargsyan may seek to make his mark in the foreign policy arena.

"Given a second mandate, Sargsyan should be able to begin thinking of his legacy," he says. "We should expect a bold move in terms of foreign policy similar to the protocols between Armenia and Turkey after the February 2008 election, where Sargsyan will feel emboldened by his new mandate to actually carry forth domestic reforms and perhaps again try making a move toward Turkey or Azerbaijan."

The Kyrgyz army blocked access to Sokh on the following nights to prevent thousands of Kyrgyz from invading the enclave in retaliation.

The hostages have been released, but the head of the Batken regional government, Zhenish Razakov, announced on January 10 that "hotbeds of tension" remain, 24.kg reported. "This is not the last conflict in the frontier zone of Kyrgyzstan, the situation is far from stable," Razakov warned.

Sokh

Sokh'd in southern Kyrgyzstan Clare Nuttall in Astana

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fter 34 Kyrgyz nationals were taken hostage by residents of the Uzbek Sokh enclave, Bishkek and Tashkent took steps to smooth over the January incident. But with the borders to the tiny enclave having to be closed and nearby Kyrgyz villages cut off from the outside world, the threat of further clashes remains, which could have a destabilising effect on the whole volatile and ethnically mixed Fergana Valley region.

Sokh, a small island of Uzbekistani territory within southwest Kyrgyzstan's Batken region, is the largest of several enclaves in the Fergana Valley and an occasional flashpoint for small-scale ethnic clashes. The recent incident erupted on January 5 when Sokh residents, angered by Kyrgyz border guards putting up pylons near the border without permission, attacked a border station and passing cars and buses, taking 34 hostages in the process.

Remnants of the past Sokh and several other smaller enclaves owe their existence to long-term land leases agreed when the region was part of the Soviet Union, divided between the Kyrgyz, Tajik and Uzbek Soviet Socialist Republics (SSRs). At that time, it was not unusual for land in one SSR to be leased to collective farms based in the neighbouring republic or for tracts of land to be exchanged. But this informal arrangement became a problem when the internal borders suddenly became international frontiers in 1991 when the Soviet Union broke up. Minor disputes around Sokh and other enclaves are frequent, with triggers including cattle grazing rights, access to water and ad hoc border closures.

The main road from Batken runs through Sokh, meaning the region's residents have to pass two international borders to get anywhere else in Kyrgyzstan.

The only alternative is the gravel track around the enclave, where cars and

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lorries churn up choking clouds of dust and few escape without at least one puncture. This has contributed to the extreme poverty in Batken, Kyrgyzstan's poorest region where around one-third of the population were living on under €5 a day, according to a 2010 World Bank report. Although it has managed to avoid conflict on the scale of the ethnic violence in Osh and Jalalabad in 2010, the area has seen many smaller clashes between the Kyrgyz, Tajik and Uzbek populations.

Jozef Lang of the Centre for Eastern Studies (OSW) points out that the recent incident is the first time when ethnic conflict in the region has overlapped with mutual animosity between the two countries. "Ethnic conflicts had previously concerned almost exclusively citizens of Kyrgyzstan

The governments of both Kyrgyzstan and Uzbekistan have shown a willingness to resolve the conflict at the national level, with the two countries planning a joint investigation. Tashkent has started paying compensation to victims of the violence, according to reports in the Kyrgyz press. "The situation between the Kyrgyz and Uzbek governments seems to have calmed, but within Kyrgyzstan there seem to be some tensions between the local population and the national government," says Eugene Chausovsky, director of analysis for the former Soviet Union and Europe at Stratfor. "There remain other serious issues, namely the

Eurasia

closure of the border and getting clean water, electricity and other key goods into the area."

Residents of nearby villages have staged several demonstrations demanding compensation. Long-term border closures would have a more serious impact on the standard of living and the economy of the region, which

raises the threat of further violence.

"The Fergana Valley is no stranger to such incidents, most of which start out locally. Most die down, but occasionally they have the potential to spread into something worse," warns Chausovsky.

"The likelihood of this particular conflict erupting into something more serious seems to be dwindling. But if the local population doesn't get access to food, water and electricity within the next few days, I think we can see the potential for protests or even violence to occur."

Dealing with Sokh has become the latest challenge for Kyrgyz Prime Minister Zhantoro Satybaldiyev's government, with several MPs calling for Satybaldiyev to resign after he failed to attend a parliament session on the issue.

The government is having to scramble to resolve the highly complicated situation in the volatile south, where the threat of a new outbreak of ethnic conflict has again taken attention from the country's pressing economic issues.

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Kazakhstan has also seen several other international drug giants open offices, including GlaxoSmithKline, which in June last year signed a cooperation agreement with the government that will involve the local production of the company's vaccines and drugs.

The closure of the borders around Sokh has isolated both the enclave of some 55,000 people, and nearby Kyrgyz villages. While Bishkek has promised to speed up construction of a new access road, this won't help in the shorter term.

On January 14, a state of emergency was declared in five Kyrgyz villages that were cut off from the outside world and began receiving helicopter airlifts of food and other essentials.

"This is not the last conflict in the frontier zone of Kyrgyzstan, the situation is far from stable"

of various ethnic backgrounds. The border crossing by Uzbek people and bringing hostages to Uzbek territory has brought a new quality and this – given the tense relations between the two countries and their mutual distrust – may have dangerous consequences in the future," Lang says.

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Drug companies target Kazakh market Clare Nuttall in Astana

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growing number of multinationals are entering the pharmaceuticals sector in Kazakhstan, drawn by steadily growing demand. The government wants to accelerate this process and officials are busy negotiating with foreign firms to persuade them to set up in Kazakhstan, but the government's target of boosting domestic pharmaceutical production to 50% of total demand by 2014 still looks over-ambitious.

Several new pharmaceutical sector deals were signed off in the final months of 2012, bringing yet more international companies to a market where three of the top five firms are now controlled by foreign investors.

Prague-based Favea Europe signed an agreement with Romat, one of Kazakhstan's largest drug makers, on October 24 during Kazakhstani President Nursultan Nazarbayev's visit to the Czech Republic. Romat plans to build two new modern pharmaceutical production facilities in the northern towns of Pavlodar and Semey at a total cost €37m. Also in late 2012, Alma

Pharma and Turkey's Abdi Ibrahim Global Pharm announced plans to build a $60m pharmaceuticals factory in the country.

The most significant deal to date was struck in September 2011, when Poland's Polpharma acquired Kazakhstan's largest pharmaceuticals company Chimpharm, and announced plans to invest $85m in the Shymkent-

Healthy growth The steep increase in demand for pharmaceuticals, driven by the growing middle class and increasingly sophisticated medical system, has caused a corresponding rise in imports.

As of 2011, Kazakhstan imported around KZT142bn ($940m) worth of medicines, around 86% of total consumption, according to IHS Global Insight, with the remainder – almost entirely generic medicines – produced by local companies.

Astana has responded by launching a new strategy for the sector, aimed at increasing domestic production to supply 50% of the drugs consumed within Kazakhstan by 2014. This is part of the government's general policy of diversifying the economy, but it is also intended to prevent state healthcare costs from spiraling, since the state accounts for around 45% of pharmaceutical purchases.

There has already been some success in increasing both the quality and the quantity of domestic pharmaceuticals.

Polpharma is bringing Chimpharm's manufacturing into line with the

"The steep increase in demand for pharmaceuticals has caused a corresponding rise in imports" based company that included the construction of a new factory.

Chimpharm and Nobel, an offshoot of the Turkish company that set up production in Almaty in 2004, are two of Kazakhstan's top six drug companies, which together account for up to 90% of all pharmaceuticals produced in the country.

Good Manufacturing Practice (GMP) standard; the factory Abdi and Alma are building will also comply with the standard. "Both of the two largest domestic producers are in the process of implementing GMP standards, with the state planning to rely on seven domestic companies to drive forward domestic industry growth via different

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Turkmen trade

investment programmes," says Kavita Rainova, an analyst at IHS.

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The government's plan has, however, been criticised for being over-ambitious and unrealistic. There are also various obstacles to competition in Kazakhstan's pharmaceutical and medical markets, according to research from Kazakhstan's agency for competition protection, which was released in December. The agency is now drawing up proposals for removing barriers to entry in the pharmaceuticals and related sectors.

With the World Trade Organization (WTO) set to welcome two new Central Asian members this year, Turkmenistan's government announced plans to open talks with the trade bloc in what will be yet another big step to bring the country out of its international isolation.

President Gurbanguly Berdymukhamedov told a cabinet meeting on January 19 that the issue of Turkmenistan's WTO entry should be considered, and instructed officials to set up a special commission on the issue and to open talks with the organisation.

The announcement comes two years after European Commission President Jose Manuel Barroso, during a visit to Ashgabat in January 2011, made a somewhat surprising proposal that Turkmenistan should look to join the trade bloc. The country's tightly state-controlled economy and dreadful human rights record hardly makes Turkmenistan a bastion of EU values, but Central Asia has increasingly worked its way onto Brussels' agenda in recent years, given its potential to offer the EU a route to reducing reliance on Russian energy. Turkmenistan sits on what are claimed to be the world's fourth largest reserves of gas, and Turkey is discussing the possibility to start shipping that fuel to Europe via the planned TANAP pipeline, through which Azeri gas is initially set to transit.

Should it succeed, Turkmenistan would likely become the fourth Central Asian country to join the global trade club. Kyrgyzstan is already a member, while Tajikistan and Kazakhstan are on the verge of joining. The WTO approved Tajikistan's accession in December, and the lower house of the Tajik parliament approved the accession agreement in January.

Kazakhstan, which applied to join the WTO way back in 1996, is also close to accession, WTO director general Pascal Lamy said on January 17. Kazakhstan would follow its fellow Customs Union founder Russia, which joined the WTO in August last year. This means that several of Turkmenistan's main trading partners are now members of the WTO.

As of late 2012, "domestic production in Kazakhstan is estimated to account for around 15% of the market in value terms. This is considerably below the 50% domestic share target by 2014, which may potentially lead the government to consider revising the timeframe," Rainova says.

Market dynamics are also set to change when Kazakhstan, a co-founder of the Customs Union with Belarus and Russia, enters the World Trade Organisation (WTO).

"While the Customs Union is expected to be beneficial to the domestic pharmaceutical industry, Kazakhstan has secured a five-year transition period before fully implementing the Customs Union requirements," says Rainova. "One angle of Kazakhstan's entry to WTO which would be positive for the foreign originator companies is the enforcing of TRIPs [Trade-Related aspects of Intellectual Property rights] and data exclusivity."

WTO director general Pascal Lamy told journalists in Moscow on January 17 that Kazakhstan's entry to the WTO "could be doable this year."

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New Ukraine govt a compromise between Donetsk groups Tadeusz Olszanski of the Centre for Eastern Studies

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he composition of Ukraine's new government that was appointed by President Viktor Yanukovych on December 24 is the result of a compromise between the two main groups of oligarchs: the "family", linked to the president's son Oleksandr Yanukovych, and the Rinat Akhmetov group of the country's leading oligarch. Expect few, if any, significant changes to domestic policy from the new government.

The "family" has strengthened its control over the cash flows, which are of key importance before the presidential elections in 2015; meanwhile, Akhmetov's group has maintained con-

"The family has strengthened its control over the cash flows" trol over certain economic sectors. The so-called RUE group (led by Dmytro Firtash and Serhiy Lovochkin) has lost much of its former influence in the government, but has retained its ability to influence the energy sector.

The shape of the new government shows that Prime Minister Mykola Azarov's role has been significantly diminished by the appointment of Serhiy Arbuzov, a representative of the "family", as first deputy prime minister, confirming his position as one of the key people in the country; and of Olena Lukash as minister for the government, who will also act as the cabinet's "caretaker" on behalf of the president.

We must not expect the new government to introduce any significant changes to domestic policy, which is still being hampered by the lack of a stable pro-government majority in the Ukrainian parliament. In its foreign policy, Kyiv will try to continue the process of European integration, despite growing pressure from Russia, which is working to draw Ukraine into the Customs Union that it leads. The fact that no one in the new government has been given responsibility

www.president.gov.ua

for European integration may portend a weakening of the Euro-Atlantic direction in Ukraine's foreign policy, but its shape will mainly depend on decisions taken by the Presidential Administration.

Azarov, who as a representative of the "old" Donetsk bureaucracy has remained outside of the major oligarchic groups, has retained the portfolio of prime minister, but his office has come under the supervision of a newly appointed minister for the Council of Ministers, whose duties include "monitoring the implementation‌ of the President's orders", and who is therefore dependent upon the president.

President Yanukovych's increasing influence is underlined by the assignment of this position to Olena Lukash, a trusted adviser of his, who has also been named as the president's representative on the Constitutional Court. This increase in the head of state's control over the government falls within Ukraine's constitutional order, as this body is appointed by the president, and not parliament.

Of the four deputy prime ministers, only two (Serhiy Arbuzov and Oleksandr Vilkul) have strong positions; the other two (Yuriy Boyko and Kostiantyn Hryshchenko) will have no influence on the most important decisions.

The first two are representatives of the major groups within the government, namely the "family" and the Akhmetov group. The other two are related to the RUE group, which has clearly been weakened, although we cannot yet say that it has been marginalised entirely. As long as Serhiy Lovochkin remains the head of the Presidential Administration, this will be the RUE group's channel of influence on Ukrainian politics.

There are many indications that the government will actually be managed by Arbuzov as first deputy prime minister and the chief representative of the "family". This group currently controls the ministries of finance, revenue and taxes (newly created), energy, ecology and natural resources, agriculture and home affairs.

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In addition to the post of deputy PM, the group led by Rinat Akhmetov (Ukraine's richest man) runs the following departments: economic development, infrastructure, regional development and construction, social policy, health and foreign affairs. The new defence minister should also be regarded as being close to this group, at the very least.

The ministers of education and justice (unchanged from the previous cabinet) are outside the "system". As yet, the new ministry of industrial policy is still vacant; it is most likely the subject of a dispute between the groups.

The new government's effectiveness will depend mostly on how much Arbuzov and Vilkul, and the two most powerful oligarchic groups behind them, will compete, and how much they will cooperate. Any further expansion of the "family" in the Ukrainian economy will cause an increase in tension between these groups. However, it seems that no significant changes in Ukrainian politics can be expected. The implementation of the most important legislative work will depend on the Party of Regions creating a stable majority in the Ukrainian parliament.

A surprising step has been the creation of a Ministry of Revenue and Taxation, which joins together the State Tax Service and the State Customs Service – two institutions which are key instruments for affecting the economy. It seems that the aim is to make collecting the state revenues more efficient, and – above all – to strengthen the "family" by introducing a new minister whom they can control into the government. Finally, we should point out the youth of the new ministers; most of them are under 40 years of age.

A major challenge for the new government will be the deepening economic recession, which could increase social discontent and lead to protests. In foreign policy Kyiv will continue to seek to sign an association agreement with the EU and for the reduction of Russian natural gas prices without making any significant political concessions, despite pressure from Moscow to join the Customs Union. However, the deteriorating economic situation could lead to Kyiv accepting the Russian demands.

Keeping the peace The scope of the changes in the government, both personnel and organisational (the removal of one ministry and the creation of two new ones), indicates that the new system is the result of a compromise, which may prove to be permanent.

This compromise is between the two strongest business and political groups in Ukraine, which has been made within the more broadly understood "Donetsk environment", which includes both of these groups.

Akhmetov, who is trying to limit the expansion of the "family" into Ukraine's economy and politics, was able to block Arbuzov's appointment as prime minister, and has retained his strong representation in government. At the same time,

"The new government's effectiveness will depend on how much the two most powerful oligarchic groups will compete and how much they will cooperate" however, he had to agree to the handover of full control over finance, mining and some aspects of energy policy to the "family". However, he still retains influence on other important sectors (notably construction and infrastructure). Both groups have also succeeded in marginalising Prime Minister Azarov, who in the previous government had four dedicated associates; in this one, he has none.

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is being solved. Some 40% of Russians used cards to pay for goods online in 2011, according to MasterCard, nearly twice as many as in 2010. And that number dramatically rose further in the last year.

And even where card payment remains a problem, companies like chronopay. ru, Russia's answer to PayPal, have appeared. Chronopay.ru was set up in 2003, but really only stared to come into its own in the last year or so and was snapped up for an undisclosed sum

by Gazprombank, Russia’s third largest bank, at the end of 2012.

Online and on fire in Russia

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Sales soar The online shopping business is becoming very serious, very fast. Oskar Hartmann, CEO and founder of KupiVIP, a leading online high fashion discounter, told bne in a recent interview that users typically start to buy things three years after getting hooked up to the internet, and work their way up to expensive items like posh clothes or jewellery after seven years. That means most of the fastest growth is still ahead as a flood of seven-year users hit the market over the next few years.

Stanley points to a raft of already successful businesses that have appeared in the last few years, such as Avito (online classified ads), Lamoda (sale of clothes, footwear and accessories), Biglion (collective purchases), Oktogo.ru (online booking of hotels), Game Insight (mobile games), Wikimart (online retailer), and AnywayAnyday (air tickets), in addition to the more established names like KupiVIP and Ozon.ru, Russia’s answer to Amazon.

Still, there are many obstacles to overcome, according to Morgan Stanley.

Despite the fast growth, credit card use is still far from ubiquitous and punters

at the end of last year. "It is not going to take another 10 years to get to that point," he said.

Morgan Stanley agrees, calling Ozon. ru the uncontested leader of Russian e-commerce, and says with revenues rising by 91% in the last year alone, the company could reach $1bn as soon as 2014.

While Moscow and St Petersburg are the richest cities in the country, e-commerce was already moving into the regions in 2012, where the bulk of the population live. "The regions were the key driver of online trade in 2012.

"The regions were the key driver of online trade in 2012" remain wary of online payment systems.

The poor state of Pochta Rossii (Russian Post) has also forced leading retailers to set up their own distribution and logistic systems, although this may change as reform of the post office gets underway (see accompanying piece).

The share of regional online stores on Yandex.Market increased from 23% to 36% in 2012," says Yandex spokesperson Ochir Mandzhikov. "Many stores are focused on regional sales. They focus advertising on regions, arrange for customer pick-up points and so on."

Outside interest The biggest catalyst behind the swelling interest in RuNet were the IPOs of email service provider Mail.ru in 2010 followed by Yandex.ru, Russia's answer to Google, in 2011.

That move out of the core cities and into the regions and beyond is crucial.

While Russia leads the development of e-commerce in Emerging Europe, most companies are looking at the wider former Soviet Union region as a single market of about 300m Russian-speakers.

Ben Aris in Moscow

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his year is being seen as a turning point for Russian e-commerce as institutional money starts to chase the burgeoning online businesses that are sprouting up here and elsewhere in Emerging Europe.

In our 2012 outlook for Russia, bne identified e-commerce as a sector to watch as the number of start-ups proliferate and a few begin to make real money. Despite the crisis (and in several cases because of the crisis), online sales have continued to grow by over 30% and many companies are already making tens of millions of dollars in revenue.

The first round of investors into RuNet start-ups (as the Russian-speaking internet is affectionately known) were mostly e-curious oligarchs, but 2012 saw the arrival of institutional funds and foreign venture capital became more active. The number of funds of any sort investing into Russian e-commerce – by far the

largest market in Emerging Europe – can be counted on two hands, but the amounts they are committing runs into tens of millions of dollars. "Russia has one of the world's largest online populations and will soon overtake Germany as the largest [online] market in Europe," predicted Morgan Stanley in a research report published in January.

The online population in Russia has been doubling every 18 months or so, resulting

according to Morgan Stanley. For comparison, Spain, Italy and France boasted 67%, 58% and 80% internet penetration respectively by last summer.

At the same time, it is getting easier to pay for goods and services online in Russia. Until recently, the lack of credit cards was a serious bottleneck – and Russians still insist on paying cash on delivery, rather than pre-paying as is usual in the West. But with the number

"Russia is already one of the biggest internet retail markets in Europe and is on course to overtake Germany to become the biggest" in a penetration rate of 67% in the 12-54 age bracket, or 58m users, according to TNS-Gallup at the end of 2012. However, there is still a bit further to go and will increase again to 87m users by 2015,

of credit cards in circulation growing exponentially (the volume of credit card transactions was up 60% over the first nine months of 2012, according to the latest data), the payment problem

Total online sales in Russia increased to $12bn in 2012, or 1.9% of the $670bn total consumer spending in the same year. In this sense Russia is not far behind the more developed markets: online retail had reached 2% of the total consumer spending in the US and UK in 2003 and 2005 respectively. Russian e-commerce is expected to hit $36bn by 2015, or 4.5% of total sales, and then $76bn, or 7% of total sales, by 2020, according to Morgan Stanley's experts.

With the volume of sales growing by an average of 30% a year, according to Hartmann, Russia is already one of the biggest internet retail markets in Europe and is on course to overtake Germany to become the biggest in the next couple of years. The total size of Russia's e-commerce market at maturity is estimated to be between $80bn and $130bn, depending on whom you ask.

Domestic companies are now moving rapidly into the new space. Morgan

Mail.ru was Russia’s first serious internet IPO and raised $912m on the London Stock Exchange in November 2010. Yandex listed on Nasdaq and raised $1.3bn in May 2011. With a valuation of $6.9bn as of the end of 2012 and revenues of $681m, Yandex is by far the most valuable internet company in all of Europe, let alone Russia. These two IPOs put RuNet on the map for most international investors, who have been forced to bone up on what is happening on the ground in Moscow.

Ozon.ru will probably be the next billion-dollar Russian IPO. The company enjoyed revenues of $300m in 2012 and will float when they reach $1bn, CEO Maelle Gavet told bne in an interview

E-commerce and online shopping are growing equally fast in other countries in the region. Tiny Estonia is probably the most wired country in the world (and has a significant Russian-speaking population), to the point where banks have been forced to close physical branch offices since so many people bank online.

Likewise, online sales in Kazakhstan in the heart of Central Asia has also been enjoying a growth of 15-30% in the last two years and online banking services are growing to help accommodate this.

While many Russian e-retailers have set up offices in neighbouring countries, the bulk of regional integration – and the business opportunities this will afford – lies ahead of them.

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Russians go online to hit the world's January sales Ben Aris in Moscow

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hristmas is high season for post offices around the world, but the Russian postal service has not one but two surges of mail over the holiday season. The second wave is due after bargain-hunting Russian consumers take advantage of the January sales abroad (a tradition not yet established at home) and have their goods sent home.

Russian Post (Pochta Rossii) is a crucial piece of infrastructure underpinning the country's burgeoning e-commerce sector. But the institution only just coped with the onslaught this year and likely will fall short next year unless there is the heavy investment that forms part of its modernisation plans.

The holiday shopping bonanza in Russia is a bit different to the rest of Europe as religious festivals follow the Gregorian calendar, which means that Christmas Day falls on January 7. Moreover, the main Eastern Orthodox Church holiday is Christ's resurrection at Easter, not Christmas. The upshot is that December 25 is a normal workday and all the

present giving happens on New Year's Eve. "The New Year for postal workers is like an exam – there is an avalanche of letters, packets and parcels," Alexander Kiselev, CEO of Russian Post, tells bne in an exclusive interview. "This December we were expecting 2m inbound international items – twice the volume from a year earlier – but we actually received more than 3m registered letters and delivered several million more unregistered letters."

However, while Postman Pat can look forward to a well-earned rest in January, Postman Pavel faces a second wave.

and massive revenues from the US and Europe, thanks to the January sales," says Kiselev. "Based on the experience of last year, the volume of orders placed by the Russians in foreign online stores during the sales will not be less than the number of gifts for the New Year holidays."

the Postal service's investment ruble for ruble. "However, the state programme on 'Developing the Information Society' that is supposed to run over 2011-2020, which was approved by the Federal Government on December 2, 2011, has no budgetary resources allocated," says Kiselev.

Kiselev warns that 2012 was probably the last year when the service managed the volume of mail without the system breaking down; the volumes of post are expected to be even higher in the holiday season in 2013.

Russian Post is now lobbying the government for more financial support, but with the end of fat budget surpluses that the state used to enjoy, the Kremlin has imposed its own version of austerity. In the meantime, the post office is committed to investing RUB100bn on its own and has already started on the construction of five automated sorting centres, as until recently all of Russia's post was sorted by hand.

Delivering change A roadmap for reform of the postal service was summited to the Russian Ministry of Communications in September and a draft law has been tabled that will make several important changes, including allowing the post office to sell shares, set up commercial courier services and provide the regulatory underpinning for a long-mooted "SvyazBank", or postal bank: two-fifths of Russian Post's revenues already come from financial services.

Improving the postal service – which was ranked in the middle of a recent survey looking at the world's biggest post offices – is also crucial to support the growth of Russia's ballooning e-commerce business, which turned over about $50bn in 2012 and is growing by some 30% a year, according to experts.

Kiselev estimates the total amount of investment needed to bring Russian Post up to par with its western peers is on the order of RUB220bn ($7.3bn), but a row over money has broken out with the government. In August last year, the company proposed that the state ante

"We expect a second wave after the holidays and massive revenues from the US and Europe" Kiselev says that the shopping habits of Russians have changed dramatically as Russians increasingly shop online. "We expect a second wave after the holidays

up RUB75.4bn for investments, which Russian Post said it would match with RUB37.6bn from its own resources. The government agreed in principle to match

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Russian reading habits change

bne Russians love nothing better than a good book and the country enjoys one of the highest literacy rates in the world, but the sale of printed books fell last year once again as increasingly large numbers of Russians switch to e-books.

The number of books published in 2012 fell to 540.4m copies, almost 12% less than the total from the previous year, which itself followed a 6% decline the year before. The number of titles printed in 2012 also fell 5% from the year before, from 122,915 titles to 116,888, according to a Russian Book Chamber report.

However, Russians are reading as much as ever, having switched to e-books as internet usage has grown and they become more available to download.

A survey from the Romir research firm found that 65% of Russians have switched from buying print to electronic books in the last five years.

While there is no data on e-book sales for 2012, in 2011 legal sales of e-books in Russia increased almost 2.3-times and was worth RUB135m rubles ($4.4m), compared with RUB60m in 2010 and RUB11m rubles in 2008, according to the federal agency for mass media.

Tinkoff brings online advertising to Russia Jahan Hoggarth in London

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ith the number of users approaching 60m by the end of last year, Russia's internet provides one of the largest audiences in Europe and is already the country's second biggest advertising market. And with no big players around yet, filling that space in Russia's online advertising was a no-brainer for Oleg Tinkoff, the serial entrepreneur who has been involved in businesses ranging from beer to online banking.

Experienced in bringing successful business models from abroad to Russia, such as the online banking, Tinkoff last year came up with his most technologically ambitious project to date: Tinkoff Digital, which will look to exploit the

growing market for new, cost-effective ways to advertise on the internet.

According to Tinkoff Digital's chief executive, Anna Znamenskaya, the idea came as a result of running Russia's only online bank, Tinkoff Credit Systems (TCS). At TCS, she explains, most of the advertising is done online and out of its 3m customers, half became clients as a direct result of online and mobile advertising. From this, Tinkoff Digital could see that attracting a customer through online advertising cost about half of that using a TV ad.

With the help of Goldman Sachs and $20m of shared investment, Tinkoff Digital kick-started the monetising of Russia's hitherto untapped online and mobile

advertising opportunities. In December, Tinkoff Digital launched its first project called "DataMind", which serves as a real-time bidding (RTB) demand side platform – a fairly new concept for targeted advertising that started its life in the US. In a nutshell, each time a web user visits a page, the RTB, as an online auction, offers advertisers the chance to bid for an impression (an online advertisement) on a page the user is about to view. The system then chooses the most relevant advertising and, as a result, the web user sees the ad that has won the auction. The whole process is over in 120 milliseconds, which allows advertisers to adjust their selling strategies almost instantaneously.

On the move Analysts predict that Russia's online advertising market will be worth $4bn by 2015, with RTB accounting for 18% of that, up from $1.9bn in 2012, which was 18% of the total media advertising budget. "TV advertising is still the biggest media for companies where the image and visual branding is crucial,

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but for many others, such as telecom or retail companies – where the immediate online purchase is possible – web advertising is ideal," says Znamenskaya.

Moving into the field of RTB with a complex approach, Tinkoff Digital has amalgamated a number of interconnected projects, including MadNet – the first Russian RTB-based mobile advertising network. The contracts for buying impressions from Google, Hunt, MobUp, MobClick and other mobile networks are already signed.

bne February 2013

Also a niche spotter and a founder of many online projects, including workingmama.ru, a website for successful and socially active Russian mums, and ivi.ru, the biggest online video portal with licensed content, Znamenskaya explains tirelessly that RTB is the "hottest topic" for advertisers around the world. "Mobile advertising in Russia and the consumption of media is growing very rapidly, but the monetisation of this market is still very low," she says.

Serving as the RTB platform, DataMind collects the online advertising space,

Russians like their data on the move

Ben Aris in Moscow What was the most popular Christmas present for loved ones in Russia in 2012? Sales of smartphones jumped before the New Year holidays, according to leading handset retail chains, promising that mobile internet will be the next big thing in Russia.

Valeria Kuzmenko, spokeswoman for the country's largest mobile operator MTS, which also owns a large phone retail chain, told Vedomosti that peak sales were registered on December 29-31 as punters scrambled to find a last-minute present. Sales at MTS’ branded retail outlets grew three-fold over the run-up to the holidays, while sales of smartphones were up by 50% on the year and by 300% compared with average daily sales.

Likewise sales at MTS’ main rivals, Euroset and Svyaznoy, were up by nearly 60% on year in terms of value between December 15 and December 31, with Svyaznoy's smartphone sales up an even bigger 86% on the year in that period.

"Sales of normal phones have continued to grow, even in the worst of the crisis years, but the fastest growth in sales is all coming from smartphones," Dennis Ludkovsky, CEO of Svyaznoy, told bne in a recent interview.

The rapid spread of smartphones is also changing the telecommunications business in Russia. Both internet penetration and the voice calls business have reached saturation points, but mobile data is still growing by leaps and bounds.

Analysts that met with VimpelCom, Russia's second largest mobile phone operator, at the start of January say the company doesn't expect to make much new money from its voice business this year. VimpelCom assumptions have its mobile voice business delivering only marginal growth in 2013, up by approximately 1% in Russia and 3% in Ukraine where it also operates. The fixed-line business is already in decline, with volumes expected to fall by 3% in Russia and 6% in Ukraine.

enriches it with data (web user search behaviour, shopping history, demographics, age, etc.) and sells these impressions to advertisers through bidding. "We collect our data from third-party providers and also during the winning of impressions, and we use it to target the advertising better," explains Znamenskaya.

Increasing the market coverage, Tinkoff Digital's next project, supply side platforms (SSP), will work with publishers (ie. websites) to monetise traffic on their websites and build the advertising network on the "big" web (that on PCs) and mobile.

Of the total internet audience, 35% do so via their mobiles and tablets, which is also 23% of the total population of Russia. And with 56% using their smartphones or tablets for web browsing, the scope for mobile advertising in Russia is evidently vast. And cheap – cost per click for mobile advertising is three- to fourtimes cheaper than on the "big" web.

And while the economic slowdown still has a suffocating grip on advertising budgets, Tinkoff Digital believes it will benefit as companies gravitate toward cheaper advertising solutions. "Our type of selling advertising space is more attractive to companies, as it will help to sell to the exact group of customers for the exact amount of money and will mean no waste," Znamenskaya says.

Yet local businesses are still slow to catch on. "There is a certain conservatism in the approach of local advertisers, who are apprehensive about internet advertising and the new technologies, so they are a bit reserved about it all," she says.

The company plans eventually to expand into Ukraine and Kazakhstan, where there are large populations of Russianspeaking web users. For now, though, Tinkoff Digital's market is currently confined to Russia – "There is so much to do in Russia – it's a vast, unploughed virgin land!" says Znamenskaya, a sentiment echoed by her boss.

"They (foreign investors) should invest in Russia! If you are young, smart and like risk, there is no better place on the earth," Tinkoff says.

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bne February 2013

New kids on the Czech tech block Nicholas Watson in Prague

I

f AVG Technologies and Avast Software (as well as ESET in neighbouring Slovakia) are the senior members of the cyber-security fraternity in Central Europe, then Cognitive Security is the new whizz-kid on the block.

Started in 2009, Cognitive Security was a spin-off out of Prague's Czech Technical University (CTU). Michal Pechoucek, one of Cognitive's founders and its chief strategy officer, explains that while it might not have been the first spin-off from that venerable institution, it was the first that was not a shared-equity structure but used a licensing model, where the university receives a royalty fee from the sales of the products that are based on the technology.

The problem with giving the university a stake in the company, Pechoucek explains, would be that any company decisions have to be reviewed by various committees, making strategic moves a bureaucratic and slow process; a licensing agreement removes that problem.

"We are nearing the second round of financing, but if we were in a sharedequity structure with the university, we probably wouldn't have approved the first round yet," says Pechoucek.

That first round of financing came from local venture capitalists Credo Ventures, which in April 2011 invested in return for a stake in Cognitive a reputed €1 million out of its Credo Stage I Fund, which targets early-stage technology companies in the region, primarily from the Czech Republic and Slovakia.

For Cognitive it was not just about the money. Cognitive founder and CEO Martin Rehak says it's one thing to a have a good idea, another to successfully commercialise it. "Credo have been textbook seed investors. They invested in us to bring a product to the market, to advise

us on the more strategic issues, and we are now looking for more investors," says Rehak. "Credo identify the golden nuggets hidden at the universities or from the spin-offs, and they help them to grow much faster than they would be able to grow on their own."

Vladislav Jez, a partner at Credo, says his venture capital firm also used its longstanding relationships in the industry to beef up Cognitive's management board. Karel Obluk (previously CEO and CTO at AVG) is now a board member, as is Richard Seewald, a partner at Zurich-based global private equity house ALPHA Associates, who also sits on AVG's board. The founders of Avast, Eduard Kucera and Pavel Baudis, are investors in the Credo Stage I fund, so are indirectly investors in Cognitive.

So what are such luminaries, and apparently a global technology giant eying the company, so excited about?

A stranger in our house Cognitive's technology first came to the attention of the US military, which was interested in its ability to monitor internet traffic for anomalies that could signal that a system was being hacked.

"It's like we are acting as the immune system of a network that finds strange or non-typical things in the body and these are highlighted," says Rehak.

At first, Rehak explains, only military or government institutions were interested in such technology because they were

"Credo have been textbook seed investors"

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the only ones being hacked at such a level. However, over the years industrial hacking has grown to a point where it has become a problem at all levels. "This problem has become much more widespread and is now a standard issue for the networks of companies, both big and small," he says. Until now, network security has primarily focused on securing the perimeters of networks, but "even if the door is locked, someone can get through the window and we can detect that," says Rehak.

This opens up lucrative new possibilities for a $10bn-15bn industry that has, to some degree, been commoditised. "Cognitive Security is in an interesting space, as the evolution of malware and malicious threats go well beyond the perimeter (handsets and PC) and now deeper into the network where valuable IP and specific disruption of business functions is targeted by hackers," says ALPHA's Seewald, whose Swiss-based private equity firm has more than $2bn invested directly in Central and Eastern Europe. "Cognitive offers security as a service platform which is scalable and protects against these advanced variations of malware for large corporates, government and small business where I believe vulnerability will be the greatest in the coming years."

Rehak highlights the fact that by being more intelligent, "we can be less intrusive, respect the privacy of the data in the network and work solely with the statistics – this is something Europeans feel very strongly about," he says.

Rehak says Cognitive's "magical ingredient" is the quality of the people it can hire from a pool that is being constantly refilled by the Czech and the region's technical universities. "We have a great team, the core of which is Czech, Slovak and Ukrainian, that is surely in our field one of the best in the world."

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AVG breaks out of security net Nicholas Watson in Prague

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VG Technologies' shares suffered after the antivirus software maker IPO'd in New York at the start of 2012, until the release of strong financial results on October 31 triggered the start of a 50%-plus surge in their price. Investors are now clearly looking at the Czech-based company in a new light.

The company announced that its net profit for the third quarter rose more than fourfold to $18.96m from $3.64m a year earlier, while revenues hit $95.25m, up 34%. With fourth-quarter revenue expected to be in the range of $94m to $98m and net profit in the range of $9m to $10m, the company consequently increased its financial outlook for the whole of 2012. Revenue is now forecast to be in the range of $354m to $358m, up from the previous outlook of $336m to $344m.

Along the way, the shares have been helped further by a search security deal signed with Yahoo! on December 14.

Under the new deal, Yahoo!'s search engine will be protected by AVG's Secure Search, which will scan links for malware and other viruses. The shares are

now trading around the IPO level of $16, a transaction that raised $128m for the company on February 2, 2012.

Analysts at the time blamed the damp squib of a stock market debut, which saw the shares tank by 18% on the first day, on the general malaise on the world's markets and a certain wariness of highpriced technology stocks – AVG came at about 20-times earnings – which had

There were also more fundamental doubts about AVG's business model, something that was exemplified by the decision of Avast Software, another Czech free antivirus software maker, to pull its Nasdaq IPO six months later due to what a spokeswoman described at the time as the "overall bad market conditions."

strong performance is being driven by its leading position in the consumer security space, as well as increasingly the growth of its internet-search business.

"The continued growth of AVG, quarter on quarter, since the IPO is in our view demonstrable of the viability of this model," he says.

Humble beginnings Both companies were set up in the early 1990s using software developed toward the end of communist rule that came out of the country's technical colleges. The going was tough in the early stages, but business really took off when AVG and then Avast became the first to change their business model to offer a basic, free anti-virus programme to protect a PC and then charge clients for upgrades and premium services. AVG now claims 135m active users worldwide.

Smith says diversification is key to surviving in this rapidly evolving business.

"If you and I were having this conversation a few years ago, we'd be discussing a free product with premium-based services – but that model won't get you anywhere today," he tells bne. "Focusing on security alone in a market that's highly commoditized between us, other premium companies, and with new players like Microsoft coming into the market, and added to that the growth rate of shipments of computers is declining, is a problem."

Last year, AVG was voted by readers of the British magazine PC Pro as the best provider of free anti-virus software, which at once highlights how popular and well respected the company's products are, but also how it's been pigeon-holed into that category of makers of free, now largely commoditised software, which many investors clearly doubt is sustainable in the long term.

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"Diversifying our product portfolio and leveraging the goodwill built by our brand for the last five years was one reason why we were able to go public because we had a more robust story to tell, not one just about premium security," he says in a sly dig at Avast.

The release last summer of AVG's 2013 product suite, which moved the company firmly outside the pure internet security business, epitomizes this. Smith says that while the core of its business will always be security, the new products include technology to increase the speed and efficiency of a user's computer; a big section on privacy, which identifies what websites are tracking a user when online and rating them to warn if there are suspicions that those sites are selling a user's information; and free telephone support in English-speaking countries on all its products, both for free and

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paid users. "Our free product is still better than most paid products – better detection and better protection, and also includes anti-spyware and a whole bunch of extra functionality including privacy," Smith says. "There are things in our free product that you can't even get in many of our competitors' paid products."

Further, in October AVG launched its cloud care product for small companies as those kinds of businesses stop being so reliant on hardware. "We're evolving from hardcore security into a 'peace-ofmind' product across multiple platforms, such as mobile, trying to make people's user experience better, faster, easier and safer," says Smith. "We're leveraging the trust of our brand that was built up in the security aspect and diversifying into other areas."

The Arta doing business in Kazakhstan

INTERVIEW:

J.R. Smith, CEO of AVG, admits that being the first in the industry to offer free products has "kind of put us a little bit in a box", but slowly the company is succeedClare Nuttall in Astana

"We're evolving from hardcore security into a 'peace-of-mind' product across multiple platforms" prompted some to warn about a possible second tech bubble forming as investors ploughed money into these high-flying stocks. Further, there were concerns with the way that AVG had used its cash pile prior to the IPO, by making a $550m dividend payout to its investors, which Francis Gaskins, head of the IPO database and research firm IPO Desktop, called quite a lot for a company with a market cap of around $800m.

ing in convincing investors that AVG has evolved from offering just hardcore security into what he calls a "peace-of-mind" product across multiple platforms – a process that's being made easier by the release of such strong financial results.

Richard Seewald, a partner at the Zurich-based private equity outfit ALPHA Associates, which was an early investor in AVG, says that the company's

K

azakhstani IT companies have had to struggle against a bias in favour of international firms over homegrown rivals. Astana-based software company Arta has managed to overcome this prejudice, and now plans to expand across the Customs Union.

Founder and CEO Bolat Basheyev says he didn't originally plan to become an entrepreneur; he set up the business simply because he needed to feed himself.

Despite winning a programming competition that gave him a university scholarship, Basheyev had to take a job

to support himself when he came to Astana, resulting in a disastrous chain of events that ended in him living rough at the city's railway station. "I was expelled from university and my dormitory room was taken away because of my low attendance. At work, I didn't receive my salary for three months, so I resigned. I had to sleep for three days at the railway station," he tells bne in an interview.

Basheyev's big break came when a friend suggested that he work on a management system for their university. "Barely holding in my emotions, I said of course."

To sign the contract, Basheyev had to register a company, which is how Arta was founded. The system he and his team developed was successful, and subsequently adopted by 50% of Kazakh universities within a few years. At the same time, the company developed a process management product for schools that was eventually installed in 45% of schools in Kazakhstan.

Since then Arta has developed more products and branched out from education into the corporate market. "We saw that companies were all buying the same three to five products such as content management, workflow and perfor-

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bne February 2013

mance management, so we decided to bring them all together into a single product," says Basheyev. Arta works mainly with medium-sized and large companies with over 50 employees, and around 25% of its business is with government and state-owned enterprises.

Across the union It's not all been plain sailing. When the craze for iPads took off in Kazakhstan, with former prime minister Karim Massimov urging government officials to invest in the devices, Basheyev decided to put Arta's software onto a tablet computer so that its customers could be permanently connected. Arta developed new mobile software and entered talks with Hong Kong-based Archos in 2010 to produce the "Kazakh iPad", as its tablet was dubbed in the local press. But the volume of tablets Arta needed was too low for the planned cooperation with Archos to be commercially viable, and the project was dropped.

Even so, Arta has steadily expanded its business; the company and its affiliates

have turnover of around $6m, which has been growing by around 100% a year since 2008. Basheyev forecasts that Kazakhstan and its fellow Customs Union states, Russia and Belarus, will be one of the world's fastest growing markets for business software in the next five to 10 years. "Europe and the US have many companies that have been established for 30 years or more; here is a new market so there are more oppor-

ware is intrinsically better than locally produced stuff. "People said companies were unreliable, and clients chose to work with global and Russian software companies. It made our job more complex, and often we didn't mention to potential clients that we were a local company."

Arta currently has around 150 partner companies across Kazakhstan, and since

"Often we didn't mention to potential clients that we were a local company" tunities," he tells bne. This is particularly true at present, as many local companies are replacing their first software packages bought around 2004.

However, he admits that Arta has had to fight the perception among potential customers, prevalent until at least the mid-2000s, that international soft-

The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS.

the launch of the Customs Union has been planning to expand into Russia.

By 2015, the company aims to have partners in all 89 regions of the Russian Federation. The current focus is on marketing and expanding the partner network, after which Arta will seek external funding to allow it to develop a new generation of products.

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+998 71 1403 706

Istanbul

+90 212 2794 248

Tbilisi

+995 59 9569 966

Kiev

+380 44 3039 530

Zagreb

+385 1 4551 565

+40 21 3104 120

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